The Economic Outlook: Patches of Morning Fog

“We will weather the weather, whatever the weather, whether we like it or not.”
—Old Scottish Proverb

Housing: Is There a Shoe to Drop?
Much like a soldier peering through a cliff-top bunker into the fog, seeking a glimpse of that first invading ship, today’s housing market participants seem to be looking for any sign of weakening in the housing market. The evidence remains mixed. On the positive side, new homes sales jumped 13% during October. The National Association of Realtors reports that U.S. home prices have increased year-over-year by 17%; that equates to a paper gain of over $37,000 per homeowner. Still, there are some warning signs:

• The November housing market index published by the National Association of Homebuilders sustained its second-largest drop in its 20-year history.
  
• The supply of unsold new homes, as reported by the National Association of Realtors, appears to be increasing. With October’s level of 4.5 months, the supply of unsold new homes is now at its highest level since 1997. That’s relative to the lowest level of 3.5 months’ supply which occurred in August 2003.
  
• The supply of existing homes on the market has also increased, to 4.9 months. The number of unsold homes is now at the highest level since 1986.
  
• Applications for new building permits, a widely watching leading indicator, declined by 6.7%, the largest drop in six years.

We’ll be watching several key barometers for further guidance regarding the degree of slowing in housing growth, including personal income growth, the employment picture, and long-term mortgage rates. As an increasing percentage of recent homebuyers are investors as opposed to occupants, many will hope for the “buy-to-hold” mentality to reign.

The U.S. Economy: It Keeps on Ticking
Eighteen months into a tightening cycle and in spite of meteorological misgivings, third quarter GDP sustained a surprisingly high upward revision of 0.5%, to 4.3%. Fueled by a continued infusion of international capital and historically low long-term rates, consumer and capital spending momentum continues. After a 300-basis-point rate hike in Fed funds, it’s difficult to fathom that 10-year Treasuries are roughly 20 basis points lower than they were a year-and-a-half ago.

November consumer confidence levels, as published by the Conference Board, rose to 98.9, from 85.2, the largest month-to-month increase in over two years. The reasons cited in the survey of 5,000 households: jobs are less difficult to find, more intend to purchase cars and/or major durable goods, and gasoline prices have been declining (although they are still 11% higher than one year ago). Nevertheless, there remain patchy clouds of skepticism. A recent survey conducted by the American Research Group found that 43% of respondents believed that the U.S. economy was in a recession. It’s likely that these particular respondents had just received their natural gas bill!

No Accommodations
As advertised, the Fed executed its thirteenth consecutive rate increase, to 4.25%, on December 13. Interestingly, the Fed extricated the word “accommodation” from the release of FOMC’s deliberations. While it may be a bit premature to conclude that the tightening has concluded, the omission seemed to send a signal that, barring an unexpected surge in inflation or drop in labor productivity, the current campaign may cease at either the upcoming January 31 or March 28 meetings.

What Will Happen When the Fed Stops Tightening?
The implied forward yield curve appears to be saying that the Fed will continue its steady course to 50 basis points from where we currently stand. Logic would dictate that the short end of the yield curve should rally as the market senses an end to Fed tightening. A “bull steepener” would then ensue.

Looking at the Fed’s last long round of tightening may be of interest. Between December 1993 and March 1995, the fed funds rate climbed approximately 350 basis points. If we compare that to the period from May 2004 to the present, today’s implied forward yield curve suggests a similar cumulative magnitude of tightening. As Figure 1 suggests, during the nine months immediately after monetary tightening ceased, the spread between two-year and 10-year Treasuries actually showed little change. Will the forces of Asian central bank dollar-denominated reserves, a global savings glut, low long-term risk premiums, and central bank transparency once again cause logic to be defied?

An Antipodean Warning Shot?
Perhaps the most extreme example of the current global trend of monetary tightening is taking place in New Zealand, where the central bank has raised rates eight times in two years, to a level of 7%. As in the U.S., the curmudgeonly approach to monetary policy has been due to heightened inflation and an overheated housing market. The effect of monetary tightening is already starting to take hold, with the economy growing at roughly half of 2004 levels and business confidence indicators sustaining large declines. With the European Central Bank and the Bank of Canada recently joining the rate-rising ranks, such leading economic indicators as the equity markets and consumer confidence surveys will be closely watched.

John Biestman is assistant vice president, senior bank analyst at the Federal Home Loan Bank of Seattle.

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