T2W Trading Community

July 14 marked the sixth week for the most recent yield curve inversion, the third since late December 2005.

In his article for Trade2Win. “The Yield Curve,” my friend John Mauldin makes an excellent case for inversions warning of potential recessions. (See
http://www.trade2win.com/knowledge/articles/general_articles/the-yield-curve/page1)
He outlines his findings in a table on page 2. Granted, inversions have been relatively good at providing warnings of upcoming recessions, but my research shows that they are even more powerful in presaging bear stock markets. Since bear markets (not recessions) do the majority of damage to portfolios, isn’t the bear market what investors should try to avoid? Like the captain who only alters course once his ship has been hit by a torpedo, by the time a recession hits, it’s too late to take evasive action.

In examining data on various yield relationships including 3-month over 30-year yields (a full inversion), Fed funds/10-year yields, 3-month/10-year and 2-year/10-year yields, the 2-year/10-year inversion provided the earliest warning of a bear market. Looking at Figure 7, there is a 100% chance of a bear market occurring within 26 months of an inversion and an 80% chance of one occurring within 12 months of an inversion. Unless it’s different this time, as some analysts have postulated, investors and traders ignore yield curve inversions at their peril.

Potential Real Estate Time Bomb

Figure 8 – The National Association of Home Builders housing market index hit 42 in June, the most pessimistic level since April 1995, in a survey of 455 homebuilders. A rating of 50 means that half see positive sales numbers and the other half see negative. NAHB Chief Economist David Seiders now expects new-home sales to drop by 13% from the record posted in 2005 with a decline in single-family homes of 9% from the record. 

Pressure Point 1: Jobs generator breakdown
Housing represents the single largest component of the economy, a point that was brought home with the revelation from Bloomberg in early July that housing-related activity has accounted for “up to one-half of economic growth since 2001.” This includes not only the construction boom but also real estate sales, mortgage lending activities, legal fees, accounting fees and the plethora of related industries. In other words, as many as half of the jobs created in the last few years have been housing or real estate related.

As real estate demand slows, job losses mount. For example, building giant KB Homes recently announced it was letting 7% of its workforce go. Similar announcements have come in banking and other housing-related industries, and the worst is yet to come. This helps explain the weak non-farm payrolls new jobs number and 25% jump in layoffs in June.

Pressure Point 2: Cheap source of cash drying up
Thanks to the lowest interest rates in 46 years in 2004 and rising prices, homeowners (currently 68% of U.S. households) had access to a cheap source of cash. As long as the value of homes appreciated, banks were only too happy to lend money to support consumer-shopping habits.

Consumer spending represents 70%+ of the U.S. economy and has not been driven by wage growth. Instead, it has been strong, thanks to the availability of cheap money (with some help from tax cuts). Once real estate prices top out, the property ATM is closed. The double whammy borrowers face is the removal of access to a cheap source of cash compounded by the higher costs to carry debt. Total credit market debt (debt at all levels of the economy) now stands at just over 320% of GDP, nearly twice what it was as a percent of the economy in the early1980s, the last time a major property market crash occurred.   

Pressure Point 3: Mounting mortgage strain as rates and prices rise
According to a 2006 Harvard University housing study, the number of households spending more than half their income on housing jumped 14% to 15.8 million between 2001 and 2004. Homeowners carrying “severe housing cost burdens” jumped most in upper-middle incomes ($60,000/annually) – up an incredible 34.6%.

Now consider this: Interest rates hit a 46-year low in June 2004 and have steadily risen since, increasing mortgage burdens by as much as 60%. In some cases, the costs of adjustable rate mortgages (ARMs) have doubled since 2004 as ARMs rates approach 7%. Those suffering under severe cost burdens increased 14% while rates were falling. This means that the homeowners’ suffering under severe housing costs will only increase along with rates.
 
How big is the problem? According to Barron’s, approximately $1 trillion in ARMs come due this year and another $1.7 trillion next year in the United States. Real estate equity totalled more than $19 trillion in Q3-2005, $8.2 trillion of which is mortgage debt. This means that nearly one-third of outstanding mortgages are shorter-term ARMs. Total mortgage debt grew $300 billion between Q4-2005 and Q1-2006 at an annual adjusted rate of nearly 15%.  At this rate, total mortgage debt would double every five years, and that is quite clearly unsustainable.