October 2, 2022 | Issue 35 ** SPECIAL ISSUE **
Three months ago, I devoted an entire issue of this newsletter to the economy and it was well received. Apparently, I wasn't the only real estate agent confused about how the Federal Reserve's actions could alter the housing market.
Today, the economy is dominating the news and the housing sector has turned on a dime. The supercharged sellers market is gone and we are trying to figure out what's ahead for home buyers and sellers.
It's a perfect time to focus on the economy. Let's start with what I wrote in June –
"We are at a point where we are saying good bye to rising asset prices, stable pricing of consumer goods, a red hot housing market, a rising stock market, record low unemployment, and a crypto market that has outperformed all investments."
Pretty much all of those things came true – asset prices dropped, the housing market has turned, and the stock market and crypto have plunged. The only piece that hasn't responded to the Federal Reserves' increase in rates has been unemployment. As I'll discuss below, that is problematic for the Fed.
It is unlikely that you spend a lot of time reading business publications or watching CNBC. I am assuming you aren't fluent in "Fed speak" or know a lot of economic terms.
In this issue, I will explain the fundamentals. I suggest you take your time reading it and not just skimming through it. After you digest it, you'll feel comfortable discussing real estate issues in the context of economic news.
These economic issues touch everyone, but they are especially relevant to prospective home sellers and buyers.
Let me know if you find this issue helpful.
Have a productive week and stay crypto curious!
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It's not a good sign when a highly-regarded economist that I follow, Nik Bhatia, entitles his weekly newsletter, "Financial Instability, Liquidity Drying Up, Alarm Bells Ringing." And Bhatia is not an outlier. All week, the financial, business, and economic news has been disheartening.
Instead of disputing the news, searching for a ray of sunshine, or ignoring it, I wanted to go beyond the headlines and understand what is going on. Below, I discuss Inflation, CPI, The Federal Reserve, Fed's Fund Rate, Terminal Rate, Prime Rate, US Treasurys, Inverted Yield Curve, Consumer Sentiment Index, Mortgage Rates, New Construction, Unemployment, Commodities, and the impact of the strong dollar on the Global Economy.
INFLATION is a measure of the decline of purchasing power and is tracked by the US Bureau of Labor Statistics. They calculate the Consumer Price Index (CPI) by measuring the average change in price, over time, of a "basket" of selected goods and services.
The CPI is based on 94,000 price quotes from 23,000 retail and service establishments, and 43,000 rental housing units. Inflation dropped from July to August, but not by enough. The August rate was 8.26%, but not as low as the Fed expected. It is also quite a distance from the 2% target inflation rate – last experienced in February 2021. Inflation is at a 40-year high. Until consumers believe that inflation has peaked and change their buying behavior, inflation won't come down. Conversely, if consumers feel that inflation is not over, they will continue spending because they don't want to pay more for goods and services over the next few months. A surge in shopping could create shortages which will then trigger higher prices. This is a cycle that won't end well.
The job of taming inflation falls on the Federal Reserve (The Fed). The Fed is mandated to use monetary policy to achieve stable pricing and maximum employment. The Fed can slow down inflation by making it more painful for people to spend money. They do this by raising the "Fed funds rate."
The federal funds rate is the rate that banks charge each other for lending cash or excess reserves. It is also the rate that commercial banks lend to each other.
On September 22, 2022, the Fed set its target range at 3% to 3.25%. This was a 0.75% increase.
The Fed's longer term projections were also revealed. Comparing the June projections to the current projections revealed that the Fed underestimated inflation. Inflation has turned out to be more difficult to control than anticipated. Their hawkish language was clear – the Fed will do whatever is necessary to bring down inflation.
Fed Vice Chair Lael Brainard said, "Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target."
The "terminal rate" is a mapping of projected rates over time on a "dot plot." It shows that the Fed will raise rates to 4.375% by the end of 2022 and it will peak at 4.625% in 2023. This implies a pace of rate hikes next year. Inflation is projected to drop from the current 8.26% to 5.4% by the end of the 2022 and 3.1% in 2023.
The prime rate is the rate that commercial banks charge their most creditworthy customers. It’s based on the federal funds rate plus 3.
The current US prime rate is 6.25%. It has not been this high since January 2008.
How is this reflected in consumer spending which accounts for two-thirds of US economic output?
The Commerce Department reported that retail sales rose in August, but that is primarily due to a rise in auto sales. Excluding motor vehicles, sales dropped 0.3%.
A reliable gauge of future consumer spending is the consumer sentiment index. It measures how consumers feel about their jobs and the economy by asking a handful of questions:
● Compared to a year ago, financially, are you better off, worse off, or the same?
● A year from now, do you think you’ll be financially better, worse, or the same?
● In a year, will US business conditions be good, bad, or other?
● In the next five years, do you think the US will see continuous good times or unemployment/depression?
● When it comes to major household appliances, is buying now a good time or bad time?
The most recent index showed that consumers feel a bit better in September than in August, but their attitude about the economy is much lower than last year. They are pessimistic about the economy long term. (This jives with the "inverted yield curve" discussed below.)
Households continue to benefit from strong labor market, and gasoline dropped since June. However, expect to see the slowing housing market weigh on purchases of goods such as furniture and appliances.
Consumer confidence is key to bringing down inflation.
Companies raise money by selling bonds. The US government does the same, except that the US bonds are secured by the government. This makes them safe because payment is guaranteed by the US government.
The bond holder, investor, pays a price for the bond and receives a yield as the bond matures. When it matures, the holder receives the face value.
The 10-year Treasury bond yield is important because it signals investor confidence.
The US Treasury sells bonds through an auction and the yield is set through a bidding process. Bonds are also sold on a secondary market by brokers and third parties.
When confidence in the US economy is strong and investors have a higher appetite for risk, they put their money into stocks and the demand for bonds is low.
However, when the confidence in the economy is waning, investors want safe investments and they flock to Treasurys.
Investors want to minimize their risk and move their money out of riskier investments such as stocks.
Economists compare the 2-year and 10-year Treasury bonds. Normally, investors expect to be receive a higher yield when they buy longer term Treasury bonds. Today, however, the 10-year yield (3.76%) is lower than the 2-year (4.22%). This phenomenon is know as an “inverted yield curve” and it signals a recession. Except for one time, an inverted yield curve signaled every recession since 1955. It shows that investors are more confident in the short term health of the economy than the long term.
The Fed wanted to see a cooling of the housing market and they certainly got it. After a series of historic increases in the fed funds rate, the housing market did an about face. Here's how that happened. The 10-year Treasury bond closely tracks 30-year fixed mortgages. When the 10-year Treasury yield moves up or down, it’s followed by mortgage rates. Today, a 30-year fixed mortgage is 6.7%. A year ago it was 3.01%. Today’s rates have not been this high since July 2007. Selma Happ at CoreLogic said, "The surge in mortgage rates has brought the housing market to an impasse. Many buyers moved to the sidelines as the cost of homeownership became prohibitively high, while sellers were unwilling to give up locked-in record-low interest rates and expectations of peak sales prices.” High mortgage rates have put the breaks on demand and sellers are reluctant to sell because the days of insanely high priced multiple offers are over. Also, sellers who refinanced are not willing to give up their current low mortgage rates.
What about new construction? US homebuilder sentiment has fallen every month in 2022 according to surveys conducted by the National Association of Home Builders.
A lead analyst for HousingWire, Logan Hotashami, said, "No new building. This is almost useless; the housing market has already gone into a recession, and the builders are done building anything new until they get rid of the excess supply they already have. We have 10.9 months of housing supply with 9.84 months in construction. The builders will take their time finishing these homes and ensuring they sell them at a price that is useful for their business model."
After the last financial crisis, home building dropped below historic norms for more than a decade. This resulted in the housing shortage that we have been experiencing.
It appears that this will continue and there will not be sufficient inventory for the tens of millions of millenials looking to buy a house over the next decade.
UNEMPLOYMENT – The unemployment rate was 3.7% in August. This remains near a half-century low of 3.5%. There are practically two job openings for every unemployed person seeking work. Federal Reserve Chairman Jerome Powell has said the ratio of job openings to unemployed workers must narrow to bring the labor market into better balance. Even though the Fed is mandated to keep unemployment low, the current rate is too low. Many economists predict that the Fed tightening won't stop until unemployment increases. COMMODITIES – Major commodity prices have been falling, including copper. Copper is used in many products and lower prices show a drop in global demand and the end of supply chain problems. This is considered a bellwether and indicates a contraction. GLOBAL ECONOMY – As The Fed raises rates to eliminate inflation, the US dollar's value is increasing around the world. This is wreaking havoc around the globe because the dollar is the world's reserve currency. According to the International Monetary Fund, 40% of the world's transactions occur with the US dollar. In Europe, the dollar's rise in value compared to the British pound and Euro, is increasing inflation which is already at 10%. Europeans are seeing 41% higher energy prices compared to a year ago. It is going to be a challenging winter. New York Times reporter Patricia Cohen wrote in "The Dollar Is Strong. That Is Good for the US but Bad for the World" that a strong dollar is also worsening starvation in Nigeria and Somalia because it is increasing the price of imported food, fuel, and medicine. Foreign investment is also being curtailed in India and South Korea.