In the latest note from the masters of the arcane at ConvergEx, Nick Colas' team looks at the historically very strong correlation between home prices (which recently hit an 8 year low: here and here) and unemployment, a foundation stone in every single QE episode as to the Chairman the only controlled variable to set the unemployment rate are average home prices, and flips it. In other words, in their Friday analysis ConvergEx try to extrapolate just by how much home prices need to rise to hit the Fed's projected unemployment rates of 8.7% in 2012 (absent the now generic labor participation rate fudge of course), 8.2% in 2013 and 7.7% in 2014. The answer is disturbing: "In order for unemployment to reach 8.7% in the Composite-10 next year (2012), home prices will have to rise by an average of 3.5%. To reach 8.2% in 2013, they will have to climb 9.4% from their current prices. For a 7.7% unemployment rate in 2014, the necessary rate of increase is 15.4%." It is disturbing because while Case Shiller predicts a 2.7% rise in 2012, we have now seen the 5th consecutive drop in home prices, and the largest sequential decline since March 2011. In other words, not only are home prices not rising, or even stabilizing, they are suddenly deteriorating at an alarming pace yet again. ConvergEx continues: "we have no doubt that the Fed knows these numbers. They know that the housing market only needs a little boost in prices and if historical correlations are trustworthy then the labor picture should begin to brighten. The biggest overhang to this relationship is, of course, the still dauntingly high level of foreclosures and still-empty houses. Only slightly less concerning is the incremental scrutiny all mortgage applications now receive from potential lenders."
And the conclusion for anyone who still does not see why upcoming paper dilution means a non-paper solution (in the form of hard assets) - "If it costs a QE III to get the 3.5% bump in real estate prices, or even a QE IV, then markets should not doubt that the current Federal Reserve will seriously consider it." At the end of the day, the only thing the Fed thinks it can control are asset prices for that most critical of assets: housing. And if rising home prices means diluting a few hundred billion more dollars, so be it. After all, we are now less than 12 months from the presidential election, and all bets are off. As SocGen predicted, expect to see massive monetary easing resume as soon as January when Obama realizes he needs something to go right or else he can kiss that second term good bye. Ironically, the lower the president's interim rating, the higher the price of gold will ultimately rise when all is said and done. Who would have thought that the worst president since Carter would be a gold bug's biggest friend.
Full note from ConvergEx:
When All You Have is a Hammer, Everything Looks Like a Nail
Summary: Even as economists and market watchers celebrate recent improvements in U.S. macroeconomic trends, both the residential housing and labor markets still appear moribund. That’s really no surprise, as the correlation between the two markets has been historically quite high. But is that correlation or causation? The Federal Reserve is clearly banking on the latter. So how much do house prices have to recover from current levels to get us to the Fed’s own forecast for unemployment in 2012 and beyond? Based on our analysis of the historical data, house prices - as measured by Case-Shiller - will have to increase by 3.5% over the next 12 months to reach the Fed’s projected unemployment rate of 8.7% for 2012. To hit the Fed’s unemployment targets in 2013 and 2014, the appreciation in residential housing will have to be on the order of 9.4% and 15.4% over those periods. These aren’t especially daunting numbers, but they do require an inflection point. House prices are still, after all, trending downward. If that requires a full blown QE III, so be it.
“During these 2 years business conditions had grown steadily worse, unemployment had increased, construction had practically reached a standstill, foreclosures had mounted rapidly, and commercial and banking failures had increased sharply…and appeals for direct governmental assistance for distressed home owners were pouring into the Nation's capital.”
Sound familiar? No, it’s not Fed Chairman Bernanke testifying in front on Congress – it’s the Federal Home Loan Bank Board’s Fifth Annual Report, published in 1937 (http://fraser.stlouisfed.org/publications/holc/issue/3011/download/4059…). In the years following the Great Depression, the report shows, mortgage delinquency rates soared as wide scale property price deflation increased the real value of outstanding mortgage debt and rising unemployment meant that more and more people were unable to make payments. Home prices also fell sharply, making it less likely that a homeowner could sell his property to pay the balance on his loan.
Almost seven decades later, we’re facing an eerily similar situation: continuing high unemployment, little new construction, an increasing number of foreclosures, bank failures, and, most notably, high mortgage delinquency rates and a seemingly endless decline in home prices.
In the 1930s, the solution was the creation of a slew of federal government agencies which purchased distressed mortgages, offered a stable source of funds for loans, and issued over one million loans for residential-mortgage and economic development. These agencies brought the mortgage market back from the brink and saved many homeowners from crippling mortgage debts:
- FHLB – Federal Home Loan Bank System
- HOLC – Home Owners’ Loan Corporation
- FHA – Federal Housing Administration
- FSLIC – Federal Savings and Loan Insurance Corporation
- FNMA – Federal National Mortgage Association (a.k.a. Fannie Mae)
Today, the Federal Reserve is trying to emulate that success – albeit using a different set of tools. Consider the following statement from Chairman Ben Bernanke: “The housing sector has been a significant driver of recovery from most recessions in the US since WWII. But this time…” (August 26, 2011) This time, housing hasn’t rebounded. Many homeowners (some estimates place the percentage as high as half) are “underwater” on their mortgages, new home construction is at one-third of its pre-crisis level, and, most importantly, home prices continue to decline.
Several weeks ago, the Fed introduced “Operation Twist” – a plan to sell $400 billion worth of short-term holdings and use the proceeds to buy longer-term debt with the aim of pressuring long-term yields even lower. A primary purpose of the program was to push down 30-year fixed mortgage rates (FMR), which are tied to the 10-year Treasury bond yield, in order to make homes more affordable and refinancing more manageable for both current homeowners and new buyers. Almost immediately after the program was announced in late September, the average 30-year FMR ticked down from 4.09% (September 23) to just 3.94% in the week ending October 7. In the last few weeks, the rate has hovered around 4.00%, among the lowest levels ever recorded for the 30-year FMR.
There has been a good amount of backlash directed towards Bernanke and the Fed for choosing to influence the housing market rather than focusing on the letter of the institution’s famous “Dual mandate”: maximum employment in the context of stable prices. Clearly, Chairman Bernanke sees the housing market as cornerstone economic issue, and one that can (when properly pushed and prodded) help create a lasting economic recovery with attendant gains in domestic labor markets.
We decided to look more closely at home prices and unemployment to see what (if any) reason the Fed had to be focusing so heavily on the housing market in its pursuit of economic expansion. We compiled data from 1997 (the first year Case-Shiller kept records for their Composite-10 Index) to the present for both home prices and unemployment across 10 major metropolitan statistical areas (MSAs): Los Angeles, San Diego, San Francisco, Denver, Washington DC, Miami, Chicago, Boston, New York, and Las Vegas. Our findings are as follows:
- There is a clear and robust correlation between the historical trends for home prices and unemployment levels for the Composite-10. As the charts below indicate, the relationship between home prices and unemployment is inverse; that is, increases in home prices correlate directly with decreases in the unemployment rate and vice versa.
- This correlation also holds true at the individual metro-area level. Some MSAs, such as Boston and New York, experienced relatively moderate declines in home prices after April 2006, increases in the unemployment rate in those regions were also modest. Not surprisingly, those areas worst affected by the housing crisis suffered significantly higher unemployment rates.
- The increase in home prices during the housing boom from 2000 to the peak in April 2006 also correlates closely with the price decline following the bust. Among the Comp-10, home prices increased 107.59% from August 2000 until April 2006; conversely, prices declined by 32.23% after the bust. Most notably, those areas that saw the largest increase in home prices during the boom (Las Vegas, Miami, Los Angeles) also saw the steepest declines when the bubble burst. Essentially, every MSA in the Case-Shiller index exhibited strong and predictable mean-reversion as they went from boom to bust.
The most obvious dataset that supports the correlation between home prices and labor markets is construction employment. As the chart shows, those areas that experienced the largest decline in home prices also experienced the largest declines in construction employment during the years following the bust – homes in Phoenix, for example, lost 56.6% of their value, while construction employment dropped 53.5%. Correspondingly, those MSAs in which construction employment declined the least had similarly modest declines in home prices during this period; Dallas home prices only declined 7.12%, while construction employment only went down 0.34%.
These correlations serve to show that the Fed’s Operation Twist (and all that Quantitative Easing – past, present and future) is in fact directed towards one of its mandates: promoting maximum employment. Clearly, the Fed sees increasing home prices as a driver of economic recovery because increasing home prices are correlated with higher employment levels and overall better economic health. By decreasing mortgage rates, it hopes to drive up home prices which, in turn, according to this analysis, should also drive down unemployment. Yes, we know that correlation isn’t always causation, but we’ll flesh out that thought in a minute.
With this in mind, we looked at how much home prices would have to rise both nationally and regionally in order for unemployment rates to meet Fed projections for 2012, 2013, and 2014. The most conservative rate estimates given by the Fed at the latest FOMC meeting are:
- 8.7% in 2012
- 8.2% in 2013
- 7.7% in 2014
By comparing changes in the unemployment rate to percentage changes in home values both on average and individually for the Composite-10, we calculated a regression analysis through which we determined the percentage increase required in home prices to achieve a particular unemployment rate. Using this equation, we came to the following numbers:
- For every 5% increase in home prices for the Composite-10, the unemployment rate drops 0.4 points.
- In order for unemployment to reach 8.7% in the Composite-10 next year (2012), home prices will have to rise by an average of 3.5%. To reach 8.2% in 2013, they will have to climb 9.4% from their current prices. For a 7.7% unemployment rate in 2014, the necessary rate of increase is 15.4%.
- Case-Shiller predicts a 2.7% climb in home prices for next year. On the one hand, that seems a pretty positive outlook, since it takes us most of the way to the 3.5% increase that gets us to the Fed’s target unemployment rate. But – and it’s a big “but” – house prices are still declining. If you want to be generous, you might say they are “stabilizing.” But they are certainly not rising.
Now, we have no doubt that the Fed knows these numbers. They know that the housing market only needs a little boost in prices and if historical correlations are trustworthy then the labor picture should begin to brighten. The biggest overhang to this relationship is, of course, the still dauntingly high level of foreclosures and still-empty houses. Only slightly less concerning is the incremental scrutiny all mortgage applications now receive from potential lenders.
The essential point, however, is that the Fed knows it has to stop the deflationary cycle in the residential housing market. Chairman Bernanke is a student of the history we quoted at the top of this note. If it costs a QE III to get the 3.5% bump in real estate prices, or even a QE IV, then markets should not doubt that the current Federal Reserve will seriously consider it. Whether low interest rates will actually do the trick is another matter. Correlation and causation look the same when viewed in a historical context.