U.S. Housing: More Good News

U.S. housing vacancy rates are beginning to fall, despite the ongoing headwinds from foreclosures.

US Housing | Foreclosures | home builders

O ur Daily Insights service recently highlighted that there are finally positive developments in the U.S. housing market. U.S. homebuilders are feeling more optimistic, and the inventory of existing homes for sale declined substantially in January.

A further piece of good news is that the total inventory of vacant homes (which includes properties for rent and for sale) is also falling. True, the level is still very high, but the number of empty units relative to population trends, i.e. equilibrium, is no longer that excessive. Put simply, the number of empty homes available should not deviate from the level implied by the population growth over a long period of time. In the U.S., the “equilibrium” level of housing inventory has risen for decades, reflecting strong population growth.

The level of vacant homes is still above 10 million units, but since 2007, the U.S. population has grown by 12.5 million. Thus, once the number of empty homes began declining in the second half of 2011, the excess inventory relative to equilibrium began to rapidly shrink.

Bottom line: The U.S. housing market still has a significant foreclosure problem, but recent positive data is not a mirage. There may still be some near term weakness in house prices but price stabilization is imminent.

Greece: Not Quite The Happy Ending

EU officials agreed to the terms of a second bailout, but the patchwork solution suggests that concerns over Greece could still cause potential negative fallout for risk assets.

Greece Risk Assets LTRO Europe

T he risk of a disorderly default by Greece has been reduced through the introduction of a segregated debt repayment account and new national laws prioritizing debt repayment. However, questions about the future of Greece (and the rest of Europe) linger.It is not yet clear to what extent the private sector will participate in the proposed deal. Policymakers assume 95% take-up, but the imposition of Collective Action Clauses might be required to force participation by reluctant hedge funds, and the impact on the CDS market remains uncertain. Moreover, a large dose of skepticism still remains regarding Greece’s ability to significantly reduce its debt/GDP load given that sharp fiscal tightening has pushed the economy into a deep recession and the contribution from potential asset sales remains highly uncertain.

This might not be the last of the deals for Greece.

We might also see Portugal and Ireland requesting the preferential lower bailout interest rates conferred on Greece. The next event to monitor in Europe is the LTRO scheduled for next week.  A large take up of three-year funding from the ECB would suggest that European banks have solved their funding issues for the next three years, though question marks regarding asset performance and recapitalization as well as the structural problems in Europe abound.

U.S. Core Inflation Is Sticky, But…

U.S. core consumer price inflation remains slightly above the Fed’s stated target, but not worryingly so.

U.S. core CPI is running at 2.3% on an annual basis. Modest inflation is broad-based – core goods, core services (excluding shelter), and the shelter component are all in the 2% range. Notable sectors where inflation is rising faster than the overall rate are restaurants (3.1% yoy) and apparel (4.7% yoy).  The latter is likely to roll over later in the year now that the spike in cotton prices has subsided. The shelter component remains problematic because it is heavily weighted in the index and currently reflects an imbalance between the demand and the supply for rental units versus units for sale, rather than a reflection of broad inflationary pressures.

Nonetheless, the Fed has been very clear about the path for monetary policy, and we do not expect that inflation will rise outside of the Fed’s comfort zone in 2012.

U.S. Treasury Yields: Range-Bound For Now

The 10-year Treasury yield will remain in a range of 1.7% to 2.5% on a 12- to 18-month horizon. 

US Treasury Yields Range Bound

O ur framework for determining the fair value for yields is based on a review of the individual components: real yield, inflation expectations and term premium. The real yield is closely tied to the expected future path of real short-term rates. Because the Federal Reserve continues to demonstrate an easing bias, real yields will remain subdued, absent any major positive revisions to economic growth.

Chairman Bernanke’s comments this week reinforced that he is not swayed by the recent improvement in jobs data. He remains concerned about the sustainability of the recovery and the amount of slack in the labor market. As for inflation expectations, they are caught in a tug-of-war between a dovish Fed and measures of realized inflation that have begun to trend lower.

Typically, continued shifts toward easier Fed policy would boost long-term inflation expectations and also push the inflation risk premium higher. However, PCE inflation has been trending lower for three consecutive months. We continue to believe that the current environment is more deflationary than inflationary and that the level of expected inflation is too high relative to the real yield.

If negative real yields are truly justified, then inflation expectations should resume their downward trend over an intermediate time horizon.  The final component – the term premium – is where the bulk of the surprise may lie.

Australia On Hold

After two straight months of rate cuts, the RBA held rates steady; a reflection of increased market optimism and moderating financial pressures on European sovereigns and banks.

Global Fixed Income Strategy | Australia On Hold

T he RBA left the cash rate unchanged at 4.25%. Governor Stevens’ tone has become much less dovish than at the December meeting but policy continues to be focused on external factors: the Chinese economy and European sovereign and bank worries. Over the past two months, market expectations of rate cuts have moderated by roughly 50 bps, however 75 bps of rate cuts over the next 12 months is still priced in.

We continue to be apprehensive of these expectations and believe they are overdone. However, longer-term spreads versus the U.S. (and therefore yield levels) are likely to remain range-bound even as policy expectations may be unwound. On the domestic front, the RBA stated that the Australian economy’s growth is near trend, inflation is nearing its target range and borrowing rates are hovering close to their medium-term average as a result of the rate cuts in the last two months of 2011.

In short, the RBA seems satisfied with the pace of current growth. Barring any major shakeup in the European debt crisis or a hard landing in China, we expect the RBA to remain on hold.

Our Global Fixed Income Strategy service continues to recommend a neutral weight for Australia in a hedged global bond portfolio. Signs of a hard landing in China would prompt an overweight allocation.