Too Much Debt
The Chair and the Vice Chair of the Fed both spoke last week. Janet Yellen testified in front of the House and Senate with this speech. Stanley Fischer’s speech was delivered here. They were basically the same speech, Yellen’s just had more fluff for the politically motivated audience.
The message was negative for housing. Allow me to elaborate.
From a broader, and global perspective, the world has taken on too much debt. This is a recent table from ZeroHedge:
Total debt-to-GDP ratios (excl. financial debt) of assorted countries
We know this mountain of debt is only made possible by the endless printing of all the major central banks, namely the Fed, the ECB, the Bank of England, the Bank of Japan and the SNB. Vice Chairman Fischer provided this batch of data on how much the respective central banks have contributed in recent years:
Central bank assets as a percentage of nominal GDP – click to enlarge.
Fischer further pointed out that ECB is trailing the others only because its QE operation is not yet underway. However, it has already been announced and is starting soon. In terms of actual numbers, the Federal Reserve’s balance sheet has risen from about $900 billion in 2006 to about $4.5 trillion today via QE1, 2, 3 and Operation Twist.
From their speeches, both Yellen and Fischer seem to have concluded “mission accomplished“. QE3 is done and their focus is now on when and how to remove the previously provided accommodation. Does that make sense?
The world as a whole is not that much different from Greece. No major economy is strong enough to support the debt it has taken on. The modus operandi is to print, or if one is in a position like Greece and can’t print, to try to borrow from tomorrow to pay for yesterday, while going hungry today. Let us look at how real estate fits into the big picture. This chart, also from the Federal Reserve, speaks for itself:
US 30 year fixed mortgage rate, average – click to enlarge.
The above chart illustrates how mortgage rates have enjoyed endless rounds of accommodation for about 35 years, since the time of Mr. Volcker, the last Fed chairman with a spine. With so much accommodation over such a long period of time, the question is, what has housing got to show for it? As Ms. Yellen testified:
“[….]However, housing construction continues to lag; activity remains well below levels we judge could be supported in the longer run by population growth and the likely rate of household formation….”
Given such a dire outlook, the Feds plan, as stated by Stanley Fischer, consists of:
“[….] with regard to balance sheet normalization, the FOMC has indicated that it does not anticipate sales of agency mortgage-backed securities, and that it plans to normalize the size of the balance sheet primarily by ceasing reinvestment of principal payments on its existing securities holdings when the time comes….”
How can they be talking about weakness and tightening at the same time?
Let us put some numbers behind the balance sheet normalization plan. This is the maturity schedule of the Fed’s assets:
Maturity schedule of assets held in the Federal Reserve’s system open market account – click to enlarge.
Year to date, the Fed has been purchasing approximately $6 billion of agency MBS per week, equivalent to about $300 billion per year. This matches the maturities almost exactly, leading me to conclude that the Fed has not begun to normalize its balance sheet, but has merely not been adding to its portfolio. Freddie Mac is estimating that there will be $1.3 trillion in mortgage originations this year. Here are my questions:
Do Fed board members really think they can remove 25% of the demand by not replacing maturing MBS, and the market will be strong enough to absorb that?
Who in the world is going to step up and buy $300 billion in mortgage backed securities in 2015, $400 billion in 2016, and so on?
Is the Fed expecting rates to go up, down or remain the same?
In conclusion, the real estate market survives by a continuous Fed effort to accommodate. As one policy started running out of steam, a new and improved policy was introduced to keep the momentum going. Providing no new accommodation is equivalent to tightening.
The complacency in evidence today is not dissimilar to that seen during the sub-prime era, when both Mr. Bernanke and Ms. Yellen admitted they did not see the problems coming. The real estate market is now accustomed to an ever increasing level of happy drugs. Now that the Fed has clearly come to the end of providing additional support, withdrawal is going to be quite painful.
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