The State of Our Deflation

By Jeff Harding

Every major Fed induced boom-bust business cycle targets a specific asset class. In the present case, and for most of the world, it was real estate. We have discussed this many, many times.

This business cycle has been correctly deemed the biggest credit cycle in history. If you have the biggest boom wouldn’t you have the biggest bust in history? That’s what we are facing now. It is called deflation and it’s not over. You could say that we are now stuck with the clean up—all those bad investments caused by the Fed induced credit expansion.

Here’s the state of deflation:

Residential Real Estate

Sales of new homes for April were up 0.3%, to a 352,000 annual rate, about the same as in March. Don’t jump for joy: in the peak year of 2006, new home starts were almost 1,400,000 per year. The supply of new homes on the market is still high, at 10.1 months. Sales of previously owned homes were up 2.5%, but 45% of those sales were foreclosures, short sales, or REO sales. Clearly bargain hunters are trying to find a bottom in the housing market. The most important thing to watch is the overhang of inventory on the market. Presently it is still very high: a 10.2 months supply. It needs to show a definite declining trend to indicate a bottoming of prices. That means that prices will continue to decline.

Mortgage Defaults

“About 12.1% of first-lien home mortgages in the U.S. were overdue or in the foreclosure process at the end of March, the Mortgage Bankers Association reported. That’s the highest ever recorded in the MBA survey and up from 8.1% a year earlier and 11.9% at the end of 2008.” The surprising thing is that 19% of those distressed mortgages were prime fixed-rate loans and 24% were prime adjustable rate loans. Job losses impact this statistic, as well as rising mortgage rates.

By the way continuing unemployment insurance claims are now at 6.79 million – an all time record. This equals 5.1% of covered employment.

Mortgage Rates and the Bond Market

Nothing is going the way the Obama Administration would like it to go. Apparently the rise in Treasuries, especially the 10 year note, caused chaos in the mortgage markets. It caused mortgage rates to jump dramatically: the average 30 year fixed rate loan jumped to 5.44% on Thursday up from 5.03% on Tuesday. The Fed has been aggressively buying Treasuries in an attempt to keep rates down, but that hasn’t worked. Buyers apparently are predicting inflation and that really shook the bond markets. The yield curve between 2 year and 10 year Treasuries climbed to 2.75%, the highest since 2003—a product of inflation fears.

Word on the Street is that the Chinese are buying shorter term Treasuries instead of their usual longer maturity spread. This is not good for the mortgage market. The Fed doesn’t have the firepower to keep rates down. I doubt they are willing to commit the funds to make it work because of inflation fears. In March the Fed said it would buy $300 billion of Treasuries over the next six months. Could that be enough? This market is much too big for the Fed to control.

This policy will backfire: as the Fed monetizes the debt, inflation will be even greater, which means the dollar will fall and things will be more expensive and consumer spending will stay low—until inflation gets out of hand. Interest rates will eventually rise. Unknown factors: will the China and Japan intervene with massive purchases of Treasuries? If so will Japan want to see a rising yen?

Mortgages and Housing

The only things driving the housing market now are falling prices and cheap mortgage rates. If rates continue to climb, which over the balance of 2009 I think they will, then that will deter buying, causing a further drop in home prices. At some point, the difference between home ownership costs and rental costs will cause people to buy homes and the market will bottom out.

Commercial Real Estate

This is the next big shoe to drop. As I pointed out before:

Two-thirds of the $154.5 billion of securitized commercial real estate mortgages coming due between now and 2012 won’t qualify for refinancing; Deutsche Bank, Goldman, and others estimate declines in commercial-property values of 35% to 45% from the peak in 2007. They believe the commercial real-estate slump will rival or even exceed the one in the early 1990s, when bad commercial-property debt played a big role in dragging the economy into a recession.

Inventories of commercial real estate are piling up and refinancing is becoming difficult. According to Real Capital Analytics, in April the volumes of properties made available for sale far exceeded the sale of all major property types: a total of $2 billion of properties in the four major sectors changed hands during the month. But $11.5 billion of properties were offered for sale. Prices are coming down.

Once we have seen real estate prices bottom out and stabilize, then we’ll see recovery. Asset backed securities, such as subprime and other mortgage backed assets will also stabilize and be able to be properly valued. Banks will have certainty as to the value of these assets on their books. It takes time and the more the government interferes with the process of deflation, the longer the recovery will take.

The Big Risk

Of course the massive credit expansion now being undertaken by the Fed could at some point overwhelm the deflationary recovery process. We’ll see higher inflation than we’ve ever seen before.

I predict price and wage controls.