Saturday, March 19, 2005

Housing and Trade: Virtuous Cycle about to Become Vicious?

by Calculated Risk on 3/19/2005 09:33:00 PM

There appears to be a relationship between housing and the trade deficit as suggested by the 2nd graph in this earlier post. Perhaps we have seen a Virtuous Cycle as depicted in the following diagram:

Click on diagram for larger image.
Starting from the top: There is no question that lower interest rates have led to an increase in housing prices. And those higher housing prices have led to an ever increasing equity withdrawal by homeowners.

A few numbers: Total mortgage debt increased $900 Billion in 2004 and $733 Billion in 2003; a significant increase from the $200 Billion in '97. In another measure called MEW "Mortgage Equity Withdrawal" (that is used in the UK), Goldman Sachs senior economist Jan Hatzius has calculated (reg. required) that homeowners have pulled $640 Billion from their homes in 2004, as compared to just $74 Billion ten years ago.

Since the savings rate has declined, it is reasonable to assume that a large percentage of this equity withdrawal has flowed to consumption, increasing both GDP and imports over the last few years. Since the annual increase in mortgage debt has exceeded GDP growth for four consecutive years (see graph 1), a large portion of this equity withdrawal has flowed to consumption of imports. Therefore it appears mortgage equity withdrawal has been a meaningful contributor to the ever widening trade and current account deficits.

To finance the current account deficit, foreign Central Banks (CBs) have been investing heavily in dollar denominated securities. Some analysts have suggested that these investments have lowered interest rates by between 40 bps and 200 bps (Roubini and Setser: "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006")

If these analysts are correct, and foreign CB intervention is lowering treasury yields, then this has also lowerered mortgage interest rates ... and the cycle repeats. The result: a Virtuous Cycle with higher housing prices, more consumption and lower interest rates.

As a result of the rapidly increasing housing prices, we are now seeing significant speculation, excessive leverage and poor credit quality of new homebuyers; all the signs of an overheated market. As an example, in this article "Miami's Changing Skyline: Boom Or Bust?", a Raymond James and Associates representative is quoted as saying: "as much as 85 percent of all condominium sales in the downtown Miami market are accounted for by investors and speculators." What happens if the housing market cools down?

The Vicious Cycle

The following diagram depicts the possible unwinding of the current cycle.


If housing cools down (prices do not need to collapse), this will lead to lower equity withdrawal. In turn this will lead to a slow down in GDP growth and lower imports.

Lower imports might lead to a lower trade deficit, depending on the strength of exports. This could lead to less foreign CB investment in dollar denominated assets. And this could lead to higher interest rates followed by lower housing prices and the cycle repeats.

The result: a Vicious Cycle with lower housing prices, less consumption and higher interest rates.