by Calculated Risk on 2/24/2006 07:26:00 PM

CNN Money reports: Cancelled home orders: Latest bubble prick?

Home builders are growing concerned about an increasing number of cancelled new home orders, which experts say could be a sign of an underlying weakness in the recent run in home prices.

Specifically, the cancelled orders could be the latest warning sign that buyers who were turning to real estate as an investment, rather than for their own housing needs, are shifting out of real estate. And that could mean that in many hot markets, the air is about to come out of over-inflated real home prices overall.

A survey recently conducted by the National Association of Home Builders of its members found one in 5 reporting more cancellations than six months ago, with 4 percent of the overall group saying the increase in cancellations has been significant.

"One in 5" and "4 percent ... saying increase ... has been significant" doesn't seem too ominous. And so far, most cancellations are not job related:

... only 15 percent citing job losses by buyers as a cause for the cancellations. The survey, which allowed the builders to cite more than one cause for cancellations, found 45 percent saying it was due to a buyer's inability to sell their existing home and a third citing the buyers not being able to qualify for financing at a time of rising mortgage rates.

But Seiders and others say a big concern is a factor not cited on the survey, the fear that cancellations are being driven by real estate investors who were ordering new homes with the intention of selling them quickly in a hot real estate market. And Seiders said many of the 72 percent of those surveyed not yet reporting an increase in cancellations are already worried.

If its really speculators that are cancelling orders that is probably healthy for the housing market over the next few years.

by Calculated Risk on 2/23/2006 07:11:00 PM

FDIC economist Nathan Powell writes: What the Yield Curve Does (and Doesn’t) Tell Us

Some Excerpts:

Historically, the yield curve spread, or the difference between short-term and long-term interest rates, has had some predictive power for the performance of the U.S. economy and banking industry. In the past, a narrowing, or flattening, of the spread has tended to foretell both slower economic growth and increased pressure on bank earnings. Furthermore, the yield curve generally has inverted—a condition where short-term rates exceed long-term rates—up to two years ahead of a recession. Based on this historical context, the flattening in the yield curve since mid-2004 has been on the minds of many economists and banking analysts. Sometimes, however, the yield curve flattens or inverts for reasons that may not necessarily foreshadow slower economic growth.

The shape of the yield curve spread also has held implications for bank margins and profits. Historically, bank net interest margins have tended to decline one to two quarters after a decline in the yield curve spread. While many banks have found ways of reducing their sensitivity to changes in yield curve spreads in recent years, the largest banks have seen their margins squeezed substantially by the recent flattening in the yield curve. And although smaller banks have been less affected so far, the earnings of all lenders will likely be affected should the yield curve remain flat for several more quarters. This issue of FYI examines the historical relationships of the yield curve with economic growth and how changes in the spread have affected banks.

The Yield Curve and the U.S. Economy

A yield curve is simply a graph depicting the yields of similar debt instruments of differing maturities. There are many yield curves and many ways of measuring the difference, or spread, in short- and long-term interest rates along these curves. A common measure of this difference is the spread between the federal funds rate, which is set by the Federal Reserve and used in pricing overnight interbank loans, and the 10-year Treasury note yield, which is linked to the pricing of traditional fixed-rate mortgages. Two other common measures of the spread take the difference between 3-month and 10-year Treasury yields or the difference between 2-year and 10-year Treasury yields. Some research indicates that calculating spreads using very short-term rates, such as the federal funds rate or 3-month Treasury yield, is a more useful indicator of future economic activity than using a 2-year Treasury yield as a short-term rate.1 In keeping with this prior research, we will focus on the spread between the federal funds rate and the 10-year Treasury yield when measuring the shape of the yield curve.

Inverted Yield Curves Sometimes Precede Recessions

Historically, the shape of the yield curve has been a useful leading indicator of economic growth. For instance, the beginning of a recession has seldom followed a period with a steep (positively sloped) yield curve within two years (see Chart 1). In fact, during months in which the spread has measured at least 200 basis points (2 percentage points), a recession has ensued within two years only 5 percent of the time. The shape of the yield curve has also told us when recessions may be more likely. In Chart 1, we see that the yield curve has inverted significantly, or by at least 100 basis points, within two years prior to each of the past six recessions.

Click on graph for larger image.

Nathan Powell concludes:

Conclusion

History suggests that the odds of recession increase when the yield curve spread flattens or becomes inverted. But past recessions only occurred with a high frequency after the curve inverted by a significant amount for a sustained period of time. Further, the yield curve spread can invert for reasons other than the possibility of slower economic growth. We have presented some of these possible explanations, which include expectations of lower long-term inflation, a recent reduction in the term premium, strong demand for longer-term debt by foreign central banks, and investment activities by pension and hedge funds. As a result, the flat yield curve spread may not be signaling increased odds of a recession at present. By the same token, the structural forces holding long-term interest rates down may be with us for some time, even as the cyclical increase in short-term rates subsides. The presence of these structural forces suggests that a flat yield curve could persist for some time.

Similarly for banks, flat or inverted yield curves have historically been associated with narrowing NIMs and lower earnings. Many smaller banks thus far have been able to insulate themselves from changes in the yield curve spread, because they have only slowly raised the interest rates they pay on their liabilities. In contrast, the largest banks have seen their liability costs rise more rapidly, while at the same time their asset yields have lagged those for smaller banks. This situation has resulted in a classic margin squeeze for the largest banks as the yield curve has flattened. Even so, it may be just a matter of time before margins for smaller banks begin to be squeezed, especially if the flat yield curve persists. Regardless of the slope of the existing yield curve—positive, flat, or negative—bankers will benefit from strategies designed to cope with the uncertainty of changing interest rates.

The author argues that the yield curve can be flat for reasons not related to a future economic slowdown. These include low term premium, low inflation expectations, demand from foreign banks, and investment activities by pension funds and hedge funds.

None of these reasons seems compelling to me. I think it is likely that long rates are low because of foreign CB activities, but what if their economies slow? Then foreign CBs will probably lower their investment in US securities leading to higher US rates.

And the low term premiums can easily reverse. Remember Greenspan's remarks at Jackson Hole?

The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher. ... Such an increase in market value is too often viewed by market participants as structural and permanent. ... But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

There is much more in the FDIC article, especially concerning bank margins.

by Calculated Risk on 2/23/2006 12:53:00 PM

The AP reports: Oil Prices Slide As U.S. Supplies Rise

Crude futures prices fell below $60 a barrel Thursday after U.S. government data showed an increase in domestic supplies of oil.

The market remained on edge, though, because of supply disruptions in Nigeria and by worries over Iran's nuclear program.

Light sweet crude for April delivery fell $1.16 cents to $59.85 a barrel on the New York Mercantile Exchange. The contract fell more than $1 Wednesday to settle at $61.01 a barrel.

This graph is from the Dept of Energy.

The supply of crude oil is above normal levels (the blue band) and rising.



The graph for gasoline also shows inventories are well above normal for this time of year and have recovered from the hurriance disruptions last year.

The agency's report also showed that gasoline demand over the past four weeks was 2.3 percent higher than during the same period a year ago -- a sign that higher prices were not slowing down motorists.

US gasoline production appears back to normal, but imports are still at an elevated level. Higher gasoline demand is being offset by higher gasoline imports.

by Calculated Risk on 2/23/2006 01:37:00 AM

Good luck Sasha! Have Fun!

For the Ladies' Free Skate, Sasha will be wearing a new red velvet dress and perform to Nina Rota’s soundtrack of "Romeo and Juliet". Enjoy.


Photo by Dave Black for Newsweek

Sasha in blue leads after the short program.

Photo from Newsweek's Can Sasha Cohen Save the Olympics?

NOTE: I will not post a spoiler. Enjoy the competition: the three top skaters in the world over the last two years are essentially tied. Irina is the 2005 World Champion. Shizuka is the 2004 World Champion. And Sasha is the 2004 and 2005 World Silver medalist and reigning US Champion.

by Calculated Risk on 2/22/2006 11:20:00 AM

From the Federal Reserve:

Roger W. Ferguson, Jr., submitted his resignation Wednesday as Vice Chairman and as a member of the Board of Governors of the Federal Reserve System, effective April 28, 2006.

Ferguson, who has been a member of the Board since November 5, 1997, submitted his letter of resignation to President Bush. He will not attend the March 27-28 meeting of the Federal Open Market Committee.

"Roger has made invaluable contributions to the Federal Reserve and to the country," said Federal Reserve Board Chairman Ben S. Bernanke. "He led the Fed's first response to the 9/11 terrorist attacks, was a strong advocate for increased transparency of monetary policy, and ably represented the Federal Reserve in important international fora. I value his friendship and counsel greatly and wish him all the best in his new endeavors."

Ferguson, 54, was first appointed to the Board by President Clinton to fill an unexpired term ending January 31, 2000. He was then appointed by President Bush to a full term that expires on January 31, 2014.

Resignation letter.

I am surprised.

by Calculated Risk on 2/22/2006 10:33:00 AM

The Mortgage Bankers Association (MBA) reports that mortgage applications increased slightly for the week ending Feb 17th.

Click on graph for larger image.

The Market Composite Index — a measure of mortgage loan application volume – was 578.5, an increase of 0.8 percent on a seasonally adjusted basis from 574.1 one week earlier. On an unadjusted basis, the Index increased 3.4 percent compared with the previous week but was down 20 percent compared with the same week one year earlier.
The seasonally-adjusted Purchase Index increased by 4.3 percent to 408.7 from 391.7 the previous week whereas the Refinance Index decreased by 4.0 percent to 1571.4 from 1636.7 one week earlier.

Mortgage rates were steady:

The average contract interest rate for 30-year fixed-rate mortgages decreased to 6.22 percent from 6.25 percent ...

The average contract interest rate for one-year ARMs increased to 5.60 percent from 5.52 percent...

Activity is still fairly high though off from the peaks of 2005. The unadjusted Purchase Index is 436.5, off slightly from 448.0 for the same week last year.

by Calculated Risk on 2/21/2006 03:06:00 PM

From PIMCO: Chris Dialynas Discusses Causes and Implications of Low Interest Rates and the Yield Curve Conundrum

Here are his views on housing:

Q: If the global economy is awash in liquidity, wouldn’t that normally lead to inflation?

Dialynas: The inflation has occurred. The inflation is in the housing market. The inverse of the current account deficit has been debt creation, and debt has accumulated in the consumer side and federal component of the economy. So the inflation that we have realized in the U.S., the U.K., Australia and other current-account deficit countries, but also in some surplus countries like China with low-priced labor and undervalued exchange rates, has been huge price inflation in the real estate markets. Housing price inflation is, in essence, the externality of this global liquidity and fixed exchange rate regimes.

Housing price inflation has some very important longer-term implications. A housing bubble leads to more investment in housing, which contributes to current GDP growth. However, if that investment were in plant and equipment of equal magnitude then we would have a productive resource with which production could be utilized to repay the current account deficit. In the case of a housing bubble and construction boom, no such product is available. The economic prospects for the national economy will rise and fall with the housing market. A pop in the housing bubble may invoke a ruinous downward multiplier reduction in the U.S. economy while the debts remain. Ultimately, the houses themselves may need to be liquidated to settle debts with foreigners.

Ouch.

by Calculated Risk on 2/20/2006 06:52:00 PM

Forbes reports: Trichet says market expectations for ECB rate hike are 'reasonable'

European Central Bank president Jean-Claude Trichet reiterated that market expectations for an ECB interest rate hike are 'reasonable'.

The ECB is widely expected to raise its main refinancing rate to 2.50 pct from 2.25 pct at its next meeting on March 2.
...
He also said that house price rises in some euro zone countries are 'not normal'.
...
In its February monthly bulletin, the European Central Bank said it sees tentative signs that the euro zone housing market is becoming overvalued following recent sharp price rises in some countries.

Some recent house price rises in some euro zone regions may be unsustainable, it said.

Trichet told the committee that the real estate sector is important for the ECB and one of the parameters that it considers when taking interest rate decisions.

And he said it is important to 'avoid further inflation of the bubble' in some euro zone housing markets.

Its interesting that Trichet commented on real estate being important with regards to interest rate decisions. I'm not sure if he is talking about targeting asset prices, or just that the real estate sector is an important part of the economy.

by Calculated Risk on 2/17/2006 08:59:00 PM

The Financial Times' Jim Pickard has lunch with Dr. Robert Shiller: The man and the bubble. A few excerpts:

What I really want to know, not least as a homeowner, is when and how the property market will crash. So I ask him.

For a man whose written predictions seem so definite - and dire - he appears loath to be nailed as an inveterate doomster. "I really don’t know what prices will do," he says hesitantly, playing with his cutlery.

But hasn’t he predicted a huge drop in US house prices? Only in some specific cities and states, he clarifies.

The professor is no doubt aware that the history of economic forecasting is littered with the names of those who made the right forecasts at the wrong time.

And more:

What, exactly, can Ben Bernanke, Greenspan’s successor, do to rescue the US economy if the property market crashes? Has the Fed already used up its one silver bullet - that of interest rate cuts?

"Bernanke thinks there is no housing bubble," says Shiller. "According to the White House website, he said recently that the fundamentals explained house price movements except in some speculative markets." The new chairman of the Fed is a "brilliant man", Shiller continues, but he has not shown any interest in behavioural economics.

And this is where he has underestimated the danger posed by real estate speculation. "He is not attuned to one of the great innovations of our time, that is, bringing psychology back into economics."

Here we come to the crux of Shiller’s theories about asset bubbles, whether tulips, shares or property: people get excited as they see the price of an asset rising, so they buy more, which pushes the prices up further until they are unsustainable. "The bubble is made by a ‘story’, by excitement and glamour," he says. And then, once a market loses that momentum, it will experience negative feedback, where people rush to sell before things worsen further.

I'm disappointed that Shiller didn't offer a suggestion as to what Bernanke could do.

Last year I provided some supply-demand diagrams to model the market dynamics of speculation that might be of interest to some readers: Speculation is the Key

by Calculated Risk on 2/16/2006 08:58:00 PM

From Barron's Online: Is It Crunch Time for Housing? (hat tip: Gary Evans for the link)

Bear markets, be they in stocks, housing or commodities, go through certain identifiable phases, like Elizabeth Kubler-Ross's famed five stages of dealing with dying -- denial, anger, bargaining, depression and finally acceptance.

"It's a three- to five-year cycle on the downside," says Kenneth Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at UC Berkeley.

Rosen calls himself a real-estate bear who endorses the doom-and-gloom scenario of Yale University professor Robert Shiller (see Barron's, "The Bubble's New Home," June 20, 2005)."

We've already passed stage one, characterized by "a falloff in new sales and orders," says Rosen, and are just entering stage two, in which unsold inventories build up.

That may be where the crunch begins.

Prospective sellers, of course, can just take their homes off the market and live in them until they think they can get a better price.

But speculators don't have that luxury: At some point they can no longer carry a money-losing investment, so they may throw in the towel and unload their once-promising albatross.

That's stage three, says Rosen, and it usually finishes about three years from the beginning of the downturn.

The final phase is when we see massive defaults or delinquencies on mortgage loans. That's several years away, he says, and this time the damage could be worse because of the large number of exotic loans giddy lenders extended to desperate home buyers (see Barron's, "Coming Home to Roost," Feb. 13)."

There is more in the article. I think the sequence is more like:

1) A surge in inventories as sellers try to get out at today's high prices.

2) followed by a drop in orders as buyers become leery of buying at the top. Historically house prices tend to be sticky as sellers want prices close to those of recent sales in their neighborhood. And buyers want a discount from recent sales. The result is a drop in orders.

3) Then prices start falling as some sellers (speculators and homeowners in distress) need to get out.

There are other economic impacts:

1) as prices stagnate or fall, homeowners will withdraw less equity from their homes and that will impact retail sales.

2) as transactions decline, housing related employment will fall.

3) and finally, as mentioned in Barron's, there will be defaults or delinquencies on mortgage loans.

Already inventories are rising rapidly. And I believe sales are just starting to decline. The next few months will be interesting.