US Housing and Economy and Reaching for Yield

Daily Commentary: 2013-02-28

Today I thought I would try a little experiment by beginning to write a daily commentary. I have been thinking about doing this for a while and decided I needed to give it a go here because I don’t have an in-depth article I am working on. So now seems a good opportunity to make some general comments on the markets and the economy.

I have a few topics in mind but let’s start with this one: housing. And then we will move on to the economy and ‘reaching for yield’. All of the recent numbers from US government data and from Case-Shiller reinforce the idea that housing is now in a sustainable cyclical recovery. And I believe this is true. I have a few thoughts about this recovery.

First, housing is important to the economy not just because homebuilding and remodelling add to economic output and employment but also because the home is the principal asset of most people in the United States. As a result, housing has household income and balance sheet effects. During this recovery from the first financial crisis wave, a lot of people saw home prices dive enough to put them into negative equity. That trapped them in homes (and cities and jobs) that they may not have wanted. It also made it impossible for these homeowners to refinance their mortgages to take advantage of low rates. With house prices now moving up again, more and more people are eligible to refinance their mortgage and they are taking advantage of this to save money. The end result is that people have more money in their pockets.

As to the deleveraging issue, the ability to refinance and the increase in home values are very important since it is households that have the greatest debt problem in the US. What we now see in the consumer credit numbers is an incipient cyclical releveraging. Consumers are now adding to their debt burdens again because they feel safe enough to do so given the housing upturn. So deleveraging has been stopped cold. And that means the credit accelerator can add to GDP instead of detract from it.

I now believe that the fiscal cliff and sequester items will not be enough to override the momentum the US economy has built up. And this is significant because it means there is a much greater possibility that the US economy maintains growth long enough to reduce a lot of the systemic fragility in the financial sector and in household balance sheets. 

All along, the real question has been: what happens when the economy turns down again? Governement debt and deficits are higher, interest rates are at zero percent and household balance sheets are worse than they were at the beginning of the last economic cycle. My view has always been that this combination sets up a situation in which political policy space for fiscal stimulus is limited, in which monetary policy must rely only on non-traditional stimulus like quantitative easing, and in which households will be in a worse position from a balance sheet perspective.

So the questions now go to how much this cyclical recovery can rebuild balance sheets and reload the opportunity for fiscal and monetary stimulus. A worst case scenario is one in which the next recession comes when policy rates are still at zero percent, government deficits are still at 5% and households have releveraged back to the levels prevailing before the crisis. This would be a toxic mix, sure to beget deleveraging, massive bank loan losses and systemic fragility in the financial sector as those losses get recognized. The whole banter about reaching for yield is worrisome in that context. It suggests that rather than seeing a more robust macro profile, we are likely to see a less robust one that makes systemic fragility and crisis more likely.

In short, I continue to be worried about the exit path and I believe we may see another financial crisis in the next downturn given the macro pre-conditions that are evolving. On a cyclical basis, however, things look a lot brighter. The US is not going to grow gangbusters but recession is looking less likely.

Those are my thoughts for today. Thanks for reading.