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Home Price Futures Curve Still Looks Weird
As we all know, shelter inflation is very important to the overall rise in the cost of living. Recently, concern about the acceleration in shelter inflation that happened between 2021 and 2023 has been dampened somewhat as the CPI for primary rents and for Owners’ Equivalent Rent have both clearly peaked.
We know that the rent deceleration will slowly unfurl over the next year, and the Fed has recently admitted that this ability to project rent deceleration gives them some comfort on that score. Now, I recently talked in one of my podcasts about why the new models forecasting rent deflation in our relatively-near future should be taken with at least a grain, and probably a shaker, of salt…but that being said, both of our models suggest rent inflation may decline to 3% by the second half of 2024, but is unlikely to drop further than that. Our newer, unique model is driven by modeling landlord costs, and it looks very promising.
Our older model has fared worse, but with good reason. It overestimated rent inflation in late 2020 into 2021, because the eviction moratorium put pressure on rents but did not affect home prices, and then underestimated inflation thereafter partly because rents had to catch up when the moratorium was lifted.
Although the first model above looks to predict much more tightly (although that’s partly because it’s a new model so we are just now generating out-of-sample data to compare with forecasts), the second model is of interest today. That model uses several different measures of home prices and related series, and blends them with different lags to generate the forecast. In other words, this model relies on the behavior of a substitute to rented housing, and that is owned housing. It’s interesting here because it is fairly typical of the way rent inflation has historically been estimated: as (mostly) a lagged function of changes in home prices. If home prices go up, then rents tend to rise because the price of a substitute is rising; if home prices fall, then rents tend to decline because the price of a substitute is falling. Microeconomics 101.
The reason I mention this is because the predictions that rents will be in outright deflation next year are partly driven by the fact that home prices peaked in nominal terms last July, and so year/year home price inflation has declined from about 21% at the peak to slight deflation, in nominal terms, recently (using the S&P Case-Shiller Home Price Index). In real terms, the Case-Shiller HPI dropped about 9% from peak to trough, and around 6% in nominal terms. So, the thought is that the absolute level of rents need to not only level off but actually decline in order to be consistent with what is happening in the housing market. And, of course, people firmly believe that not only do high interest rates cause declines in housing activity but also (despite the lack of evidence) in home prices. I’ve been pointing out for a while that that’s not historically true – home prices in the 1970s never declined in nominal terms y/y and mortgage rates were high and variable.
Well, today the S&P Case-Shiller Home Price Index was released and once again surprised to the upside. In nominal terms, home prices are almost back to the highs although they remain a bit below the highs in real terms.
Now, I showed the SPCS 10-city, rather than the whole index, for a reason. The broader index looks the same, but you can’t trade futures on it. What is really fascinating to me is not just that home prices have rebounded faster than I expected – there really is a shortage of houses out there – but that the futures market is pricing in declines after September and that home prices will not reach a new peak until at least 2027.[1]
Look, I definitely believe that a recession is in store and we may already be feeling some of it although weakness in China could help hold it at bay for a bit longer. But higher interest rates have actually slowed down some of the home building that was addressing the housing shortage; moreover, in an inflationary environment such as the one we are in right now home prices can fall in real terms without falling in nominal terms. That misunderstanding…that ‘bubbly’ home prices would have to be resolved with a steep decline in nominal home prices…is why at one point the Feb 2024 CME Case-Shiller Home Price Futures contract traded as low as 268. That price implied a 19% nominal decline in home prices from the high, on top of inflation running at 3-5% per year, in a housing-shortage environment! As the Case-Shiller numbers have persistently run far ahead of that worse-than-the-global-financial-crisis scenario, the futures have slowly pinched higher. But it is amazing to me that, even has nominal home prices are about to reach new highs, that the market is pricing in a second decline in prices before a weak multi-year recovery!
Futures markets show where risk clears, not where investors think the price will be in the future. So what this is really saying is that people who want to hedge home prices outnumber those who want to buy homes cheaply. And that’s plausible to me. But it still seems amazing! And it also means that the following wind the Fed believes they have from disinflating rents…may not be as strong a following wind as they currently expect.
[1] Disclosure: I run a long-only strategy that passively uses this (fairly illiquid) contract, and so I am always net long. But, for what it’s worth, it actually works against my long-run interest to have the longer contracts trade up to make my future rolls more expensive, so hopefully you’ll all think home prices should be going lower.
Three Pertinent Inflation Observations
I have three items to discuss in this week’s post.
The first item is an announcement made by the BLS on Tuesday regarding upcoming changes to how the CPI for Health Insurance will be computed.
The backdrop for this change is that the CPI for Health Insurance is an imputed cost for the CPI. When a consumer buys health insurance, he/she is actually buying medical care, plus a suite of insurance products related to the actuarial benefits of pooling risks (that is, it’s much cheaper for people to buy a share of an option on the tail experience of a group of people, than it is for each person to buy a tail on their own experience – which is the main benefit/function of insurance). If all of the cost of health insurance was actually for health insurance, the weight of medical care itself (doctors’ services, e.g.) would be quite low because most of us pay for that care through the insurance company.
So the BLS needs to disentangle the cost of the medical care that we are buying indirectly from the cost of the embedded insurance products. The link above goes into more detail on all of this, but the bottom line is that once per year the BLS figures out what consumers paid for health insurance, how much of that was actually used by the insurance company to purchase health care, and therefore how much is attributable to the cost of the insurance product. Because they do this only once per year, and smear the answer over 12 months, you get step-wise discontinuities in the monthly figures. For many years this was not a big problem, but since 2018 there have been several fairly significant swings. The chart below shows the m/m percent change in health insurance CPI. You can see it went from stable, to +1.5% per month or so in 2018-2020, to -1% for 2020-2021, to +2% for 2021-2022, to -4% in the most-recent year.
That latest period has been a significant and measurable drag on the overall and core CPIs, and it was due to reverse starting with the October 2023 CPI released in November. Estimates were that it was going to be something like 2% per month, roughly. The change announced above introduces some smoothing so that these swings should be significantly dampened. The basic method doesn’t change, but it should be smoother and more-timely since the corrections will be every 6 months instead of every year. In order to make the new calculation method match endpoints, though, this means that starting in October, the +2%ish impact will bedoubled because the BLS will make the ‘normal’ adjustment but smear it over 6 months instead of 12, then transition to the new method.
The implication is that Health Insurance, which will have decreased y/y core CPI by about 0.5% once we get to October, will add 0.25% back over the 6 months ending April. So, we already know about a significant swing higher in core inflation that is coming soon. Take note.
The second item I want to note is M2. It’s a minor thing at this point, but after three months it is worth noticing that M2 is no longer declining. It isn’t a lot, as the chart below shows, but the three months ended April showed a contraction at a 9.6% annualized pace and the most-recent three months saw an increase at a 3.7% pace.
In the long run, 3.7% would certainly be acceptable but remember we still have some M2 velocity rebound to complete. What is interesting is that this is happening despite the fact that the Fed is continuing to reduce its balance sheet and loan officers are saying that lending standards are tightening. It may simply be a return to normal lending behaviors, with a gradual increase in loans that naturally accompany the rising working capital needs of a growing economy. Remember, banks are not reserve-constrained at this point, so they’ll keep lending. Anyway, I don’t want to make too much of 3-month change in the M2 trend, just as I was reluctant to make too much of those early M2 contractions…but this is what I expected to happen. I just expected it earlier. We will see if it continues. If it does, then that in concert with the natural rebound in M2 velocity means that further declines in inflation are going to be difficult, and we might even see some reacceleration.
Finally, the third item for today. In my podcast on Tuesday, I asked the question whether China’s recent sluggish growth, caused partly by its property bubble and overextended banks, meant that we should be looking at recession and disinflation in the US – which is the current meme being promulgated by many economists. I discussed the 1997-1998 “Asian Contagion” episode, and explained that a recession in a “producer” (net exporting) country hits the rest of the world very differently from a recession in a “consumer” (net importing) country like the US. A recession in consumer countries causes recession in producer economies, because the consumer economies are ‘downstream.’ On the other hand, a recession in producer countries can have the opposite effect on its customers – because, when an economy like China is in recession, that means it is providing less competition in the commodity markets that we also use. In turn, that means we can actually grow faster, all else equal.
This is what happened in the Asian Contagion episode, and I wanted to put some charts around that. The Thai baht was the first domino, and it collapsed in August 1997. It wasn’t until fears that the Hong Kong Dollar would de-peg from the USD, in October of that year – precipitating a 7% one-day drop in the Dow – that people in the West started getting very concerned and the Fed started citing troubles in the former Asian Tigers as a downside risk. Here are charts of the period. The first one shows quarterly GDP, which never increased less than 3.5% annualized; the second is median CPI, which was continuing a long period of deceleration from the 1980s prior to the crisis…but which began to accelerate in mid-1998.
The bottom line is that as long as our export sector is relatively small and as long we remain a developed consumer economy, weakness in producing economies is not a dampening effect for us but rather, if anything, a stimulating effect.
Summary of My Post-CPI Tweets (July 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
- Welcome to the #CPI #inflation walkup for August (July’s figure).
- At 8:30ET, when the data drops, I will run a bunch of charts. Because Twitter has made auto-posting them difficult /impossible, I’ll post those charts manually with commentary as I go. Then I’ll run some other charts.
- Later, I will post a summary of these tweets at https://inflationguy.blog and then podcast a summary at https://inflationguy.podbean.com. Thanks again for subscribing!
- Get ready: today will be a low number, and good news. But it’s about as good as the news is going to get. Y/y core will decline again next month, but the monthlies won’t keep improving.
- This month, the forecasts get a large drag from Used Cars. And in fact, Used Cars creates downside risk to these numbers – it has surprised significantly on the high side for multiple months. If there’s payback, it could be a LARGE miss.
- The y/y figures for used cars have been in line with y/y figures from Black Book, so it’s possible that the recent misses have just been because of some odd seasonal quirk.
- If so, then no payback is necessary and we’ll get something like -2.5% (my forecast), plus or minus a couple of tenths. (That’s somewhat joking since this series is very volatile).
- I actually wrote a column (on the blog) about the volatility of these various series. While everyone thinks inflation is going to drop swiftly back to earth, the volatility of the numbers hasn’t done so. And that’s a tell.
- This is rolling 12-month volatility on used car CPI. The picture looks similar for lots of subcategories.
- The basic idea is that if everything was returning to normal in terms of the trend inflation level and the placid behavior of it…then we’d also see the VOLATILITY of inflation plunging back to normal. Not yet.
- Looking back at those forecasts, I should point out that I’m again (and annoyingly) right about where the consensus of economists is. Kalshi is lower, though it has been trending higher. Again, I do think there is downside risk to this figure.
- OER and Primary rents I have penciled in at +0.43%, sequentially slower from +0.45% last month. There is further slowdown coming, but we aren’t going to zero as NTRR and other models are predicting.
- I really like our new model, which is not just functionally a lag of property prices (which drives most models) or a straight lag of less-accurate (but current) rent figures. I write about the model in this quarter’s Quarterly Inflation Outlook (due out Monday).
- Because a lot of the drag this month is going to be from Used Cars, and we collectively feel pretty confident about that, it’s going to be critical to look at Median. Last month it was 0.36%, and the last several have been much better than those from the prior year.
- So again, all of this is good news. But we are using up a lot of the good news, and while everyone will extrapolate today’s CPI if it’s good news be careful about that.
- This month will also gets flattered on the headline from declines in piped gas, and the rise in gasoline won’t hit until next month. Oh, and gas is rebounding too.
- In the big picture, ‘supercore’ (core services less rents) is still the main category of interest, knowing though that it’s dampened by Health Insurance.
- Along those lines…the large rise in UPS compensation is emblematic of the new muscle of labor and a reminder that the wage-supercore feedback loop is still operating.
- Again, don’t get too excited by today’s good news! The big picture is: money stock contacting, but money velocity recovering (fastest 3q rise ever). Core goods down and dollar strong.
- But government deficits are rising again, partly because interest costs are skyrocketing. This federal dissaving isn’t seeing offsetting domestic (or international) saving. So expect more pressure on interest rates. And it sets up a future dilemma for the Fed.
- We aren’t out of the woods yet. I think inflation is going to ebb to the high 3s/low 4s on median CPI, but then get pretty sticky. And the next upthrust in inflation will start from a much higher level than before.
- But that’s all far away. In the meantime, inflation markets have been relatively calm with breakevens up a little bit over the last month and real yields hovering just below 2%.
- It would be a great place to have the market find balance, around long-term fair value on real yields. But…inflation volatility suggests it’s far too early to declare victory on inflation for all time.
- Good luck out there!
- OK, 0.167% on core. Numbers still coming in, waiting to see how much was Used Cars. Rents were behaved.
- Sorry, that was 0.160% on core. 0.167% was SA headline.
- Used cars was -1.34% m/m, so about half of what I expected and the general consensus. So what dragged?
- Charts will follow in a few. OER was +0.49%, a bit higher than I expected; Primary rents +0.42%. Lodging Away from Home -0.34%.
- Wow, another huge drop from airfares. Remember last month’s -8.11% drop was almost unprecedented? Well, we got a second month of the same. That seems implausible. Not sure what’s happening there!
- Core goods, thanks to Used Cars mainly, dropped to +0.80% y/y. Core services is still high, but fell from +6.2% to +6.1% y/y.
- The diffusion things will look interesting. Of the 8 major subcategories, Housing was +0.35% m/m but no other category was higher than +0.23% m/m (and that was food). Next highest was recreation at +0.12%.
- Not my normal first chart but here is y/y CPI for pharma. It was +0.58% m/m.
- OK folks – here’s m/m core CPI. As I said, don’t get used to this low level. But it sure LOOKS like we’ve gone back exactly to 2% and stuck the landing!
- Here are the 8 major subgroups I mentioned. Very tame m/m.
- Now THIS is the big chart. This is Median CPI. I want to look at the subcomponents – Other Food at Home was the median category. This is the best news in the report.
- Here is the rent chart. Our model has them going to ~3% over the next year. Unless core goods keeps dropping (which means the dollar continues to rally) it’ll be hard to get inflation back to 2% if housing is at 3%. Only reason it happened before was core goods deflation.
- To that point, core goods needs to go negative if you want to get back to 2%. And I think even then it’s difficult unless wages crash back down. No sign of that at the moment.
- Four pieces. The interesting bit is that core services ex-rents actually rose slightly y/y.
- More on Median. It clocks in at +0.19%. Amazingly, that’s despite all of the OER subcomponents being higher than that. Usually to get a low number you need at least one of the big-weight pieces to be there.
- But in this case, we had Recreation, Medical Care Services, New Vehicles, Housing Furnishings and Operations, all 4% or higher weights and all less than 1.5% annualized m/m.
- That starts to look a little quirky. If even one of the 1% categories had been higher then the median category would have been Fresh Fruits and Vegetables and the m/m would have been 0.29%. Still low but not the number we will see.
- I’ll have the diffusion charts in a minute and those are interesting. So, low core and median – you’d think a lot of really low categories right? But only ones below -10% annualized were Public Transportation (-54%, flag that!), Used Cars/Trucks (-15%), and Misc Pers Goods (-11%)
- On the high side we had Motor Vehicle Maint/Repair (+13%), Infants’/Toddlers’ Apparel (+17%), Motor Vehicle Insurance (+27%), plus a couple of non-core categories.
- But there were a LOT between -10% and +1.4% annualized.
- Core ex-shelter fell to 2.62% from 2.80%. It was lower in early 2021 but this is improvement obviously.
- as I said the airfares piece is really odd. Never have had 2 back to back months like that EXCEPT at start of pandemic and that was with jet fuel prices plunging. They’re not. This is…hard to believe. It’s a one-off last month I said we could be sure we wouldn’t get again! [First chart is m/m, second is y/y.]
- You really can go either way on this number. Here is the Enduring Investments Inflation Diffusion Index. The disinflation is continuing, and that’s good news. OTOH, we have some really crazy outliers like airfares.
- Here’s where CPI Airfare sits relative to jet fuel (seasonally adjusted). We are likely to see a catch-up in this next month. I am really curious which routes are getting lots cheaper. I haven’t seen it.
- Now, maybe airfares is a micro effect here that indicates a softening in travel and an early warning of decreased consumer spending. Maybe it’s a bullwhip – after “revenge travel” everyone is going back to normal travel demand. Still, betcha we don’t get another -8% next month.
- OK last chart. This is y/y but it looks similar m/m. The high bars on the right are shelter and they’re moving left. Few huge outliers on the right. Then lots of little categories strung out between 3 and 7%. Then about 22% less than 2% including 17% in outright deflation.
- The outright deflation ones are mostly core goods, and they’re not generally going to stay there. So what we are going to see over next year is all of these things starting to trend back towards the middle. Where’s the middle? I think it’s high 3s, low 4s. But that’s the question.
- Bottom line here. Overall number pretty close to expectations. There is nothing here that would argue that the Fed ought to keep raising rates – inflation is drifting lower, and nothing they can do will speed that up.
- Indeed, nothing the Fed has done so far has caused this, except inasmuch as higher rates helps the dollar which helps core goods to decline. Now…the Fed also oughtn’t ease any time soon. There’s no sign of deflation here or even stable sub-2% inflation.
- Ergo, I think we are going to see the Fed basically go to sleep here for a while, unless the bond market starts to get sloppy because of the huge demand from Treasury. If the Fed needs to intervene and buy bonds…that will be a very bad sign. But not going to happen today!
- Thanks for tuning in.
We knew going in that this would be a soft number, and that it also would likely be the softest in a while. We didn’t get as much of a drag from used cars as we expected, but we got some; the real culprit was the large drag from airfares. It’s hard to understand that one, but especially with jet fuel prices back on the rise we are going to get a give-back from that next month in all likelihood. Indeed, the August CPI is shaping up to be sobering. Core should be above 0.3% m/m again, and headline is currently tracking at 0.65% or so on a seasonally-adjusted basis. So store the party hats for now.
That said, it was encouraging to see so many categories with small changes on the month. There were enough changes that median inflation is going to print very low, 0.19% or so, this month. If that were to recur it would be a great sign. Alas, it’s very unlikely that we will see another median like that very soon. As it was, it was almost an 0.29% as the next category above the median one was that much stronger.
From a market perspective, this is positive. That’s partly because “the market” tends not to look ahead very much (yeah, I know you learned something different in school but “the market,” especially in a day dominated by mechanical trading based on parsing the news headlines, does not discount the future very well any more. That’s one reason why we keep having periodic mini crashes when reality abruptly intrudes). This inflation number gives no real reason for the Fed to hike rates again. As it was, the argument for another 25bps after 500bps have been done was always very weak, especially since there is no real evidence that interest rate hikes do very much to inflation. At some point, the beatings get to be gratuitous and sadistic.
The problem is that there is going to be pressure on longer-term interest rates given what’s happening with the budget. I’m watching that carefully. As I write this, 10-year interest rates are back above 4%. With data like this, that doesn’t make a lot of sense. But there’s a lot of paper out there and it may need higher rates to find its “forever home.”
So, enjoy this print. It’s legitimately positive news. Only the folks looking ahead to next month ought to be less cheerful but in the meantime eat, drink, be merry, and buy stonks.*
* This is tongue-in-cheek naturally.
Three Colliding Macro Trends
It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).
Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.
But let’s get back to what I’d intended to talk about.
Here are three big picture trends that are tying together in my mind in a way that bothers me:
- Large, and increasing (again), federal deficits
- An accelerating trend towards onshoring production to the US
- The Federal Reserve continuing to reduce its balance sheet.
You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.
This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.
Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:
The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).
So here’s the problem.
The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.
And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.
I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…
There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.
None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.
One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.
