30 Year Treasury Bond - Linchpin of Prosperity

Above find an intraday graph of the Dow Jones Industrial Average for May 24th. As you can see, it spiked sharply that morning at 10am (9am Central Time) when new home sales data came in "better than expected". From Briefing.com,

Economic Perspective: Review of New Home Sales data

New home sales in April took a surprisingly large 16.2% jump to 981,000 annual rate. This follows a modest gain in March. It is hard to conclude from this increase that the problems in the housing market are over, but this will certainly ease concerns about the severity of the problems in the new home market. It is clearly bullish from an economic and stock market standpoint because it lessens the downside risks... The major indices have seen a strong move to the upside on this morning's data, with the Dow pushing higher by ~60 points following the data, the SPX gaining 5 pts, and the Nasdaq gaining 5 points on the release.

I shorted into this spike of the market and quickly made some good money. I shorted because the sales "volume" of new homes (or existing homes) remains a wholly irrelevant metric. All that matters is the PRICE of home sales - at least as far as the larger economy is concerned. Getting aroused over a sales jump would be as silly as celebrating a high volume day in one of your stocks. But nobody really cares if Google traded 2 million shares on a given day or 20 million shares; they care whether or not the stock went up or down.



Home prices are dropping, in fact quite rapidly these past two weeks. I know this from watching the 30 year Treasury bond. No anecdotes from brokers or aggregate national sales data can refute the mathematics of Higher Rates = Lower Home Prices.

First of all, almost nobody knows this. They may sense it but I have never seen or heard the naked math discussed anywhere. So I'll provide that service presently.

On May 8th, the 30 year yielded 4.80%. Two weeks later, as I type this, it's yielding 5.03%. So essentially, rates have risen a quarter point (23 basis points). That lowered the theoretical value of every home in America and I will tell you by exactly how much.

Consider four theoretical homes priced at: 250k, 500k, 750k, and $1 million bucks.

When 30 year fixed mortgage rates are 5.75%,

A 250k house costs $1,459 per month
A 500k house costs $2,918 per month
A 750k house costs $4,377 per month
A $1 million house costs $5,836 per month

(These figures represent total capital costs of homeownership. It doesn't matter how much money you put as down payment on the house because the total cost of lost interest on your down payment and paid interest on your mortgage always adds up to the capital cost of the home's price.)

Now when interest rates rise, obviously a given monthly payment doesn't mortgage as much as before. To find out how much, change the interest rate on a mortgage calculator and then lower the principal amount until the monthly payment equals the level before the rate change.

You'll find out that at 5.75%, a $1,459 payment covers a 250k house, but when rates rise to 6.00%, such a payment only buys a $243,300 house.

Continuing, a 500k house drops in value to $486,700.

A 750k house becomes a $730,200 home.

And a $1 million house depreciates to $973,500.

As the math illustrates, every house in America just lost about 2.65% of its value.

This semi-dated link I found says that American consumers owe $8 trillion in mortgage debt. Since consumers own about half of their homes these days, impute the total value of housing real estate is around $16 trillion.

Therefore, the recent bump in rates shaved roughly $424 billion (2.65%) from the coffers of homeowners.

$424 billion !!!!

Now let's do the math again, only with a theoretical rise in rates from our current 5.75% to 7%, 8%, 10% and then 15%.

Here's how much every house will depreciate for given higher mortgage rates.

-12.28% at 7%
-20.47% at 8%
-33.50% at 10%
-53.80% at 15%

I believe that within three years, we will see 8% mortgage rates. So I am forecasting an approximate 20% decline from today's levels.

Devil's Advocate - But if they have a fixed mortgage, homeowners are safe, right?

NO.

Their payments for that particular house may be locked in at a set rate, but the proceeds from any sale of the property will theoretically be 2.65% lower; also any potential home equity loans would be lower. Remember, the value of your home has nothing to do with what you paid for or put down on the house - it's wholly determined by what OTHERS can currently pay for it.

Say this homeowner lived in a development of identical houses and wanted to move down the street into a facsimile of his current house. He couldn't do it without incurring higher costs. Allow me to illustrate how this fixed rate borrower is still at risk to interest rate pops.

Joe Blow just paid 600k for a house in this mythical neighborhood of identical homes. Every home there is currently worth 600k. Joe Blow puts a 100k deposit down and mortgages the 500k balance.

Suddenly every home is now worth 550k due to an interest rate spike.

Joe decides to sell his house and move down the street into another house that's also now worth 550k.

He sells his original house for 550k, uses $500,000 of it to pay off his mortgage, and used the 50k he has left as a down payment on his "new" house. Obviously Joe needs to borrow 500k more in mortgage debt, ONLY HE HAS TO DO SO AT THE PREVAILING HIGHER RATES NOW - so his payments are higher than they were before.

Joe Blow bought his first house and "locked" into a fixed mortgage. He thought he was safe from the bond market - HE WAS WRONG. Now he has zero equity (instead of 100k) and he has higher payments and an equal debt for the exact same type of house!!!

Many people mistakenly think that once you buy a house, they are insulated from larger market fluctuations but that is only true if rates stay the same.

In America, one cannot take their mortgage with them when they move (in Britain it may be allowed). They need to take out an entirely new loan at market rates. After all, a mortgage is a loan based on a specific house. The specific location, price, timing, and financial status of the borrower were extremely important variables for the lender. The lender doesn't want what they had previously deemed a safe loan transferred to another property, in another town, on a differently priced home, when the financial status of the borrower may or may not have changed.



I want to make a few more points about how important the 30-year bond is to our economy.

When interest rates tick up as they just did, it's not just homes that lose value. All income bearing assets lose some value because they compete with Treasuries and corporate bonds for funds. Everything from gas stations, to hardware stores, to shares of stock, to professional sports franchises lost a couple of percentage points of value over the last few weeks. Cars and college tuitions got more expensive because they rely on financing. Name just about any enterprise or product and it recently got pricier to underwrite and produce.

Now this leads to my second point.

Right now, real estate has consumers in an inflationary vice. Residential rents are rising. Commercial rents are rising - they always do but are on a meteoric rise now. Allow me to explain. Most businesses sign ten year (or longer leases). So when they expire, they'll be reset in an entirely different (higher) real estate market. You may have noticed several of your favorite restaurants or stores suddenly closing. "How could that be...", you wonder, "they do a good business there?" Well, their lease was probably up and the building owner can likely get a whole lot more rent from say a real estate agency, a pharmacy, or a corporate restaurant chain. (Have you noticed how the CVSs, Duane Reades, and Walgreens are taking over everywhere? It's because they make so much money from prescription drugs that they can pay exorbitant rents, that little delicatessens and bakeries can't compete with.) The reason commercial rents are rising so much more than normal is because the economic landscape has grown extraordinarily since 1997 - remember, back then, the internet was just a novelty. We've had the greatest bull markets in both stocks and bonds (real estate) crammed into a mere ten years. Your bakeries, restaurants, and bars will still be around but expect some real expensive shopping there going forward - after all, they have to pay their ballooning rents.

It's easy to see how rising rents (commercial and residential) are inflationary events for consumers, but house prices are dropping, that has to be deflationary, right?

WRONG.

If nobody owned a home, declining house prices would be a very good thing. BUT, about 70% of households in America now own their home. This dropping market is only a deflationary event for first time home buyers like me (though my rent is ticking up slightly).

The housing malaise may be deflationary for plasma televisions, sheet rock, and granite countertops, but it's absolutely inflationary for consumers. This was always just an undeveloped intuition of mine. I figured that home equity was in part a major currency and any depreciation of a currency could be deemed inflationary because it represented a loss of purchasing power. So then, is home equity a currency? Well, Americans re-mortgage their homes to send their kids to college. They use it to buy vacation homes; and they use it for estate planning/life insurance. Etc. It defies all my experience to NOT see homes as veritable ATMs for most Americans.

Recently Taylor sent me an insightful article that had a more illuminating take on the interplay of home ownership and inflation.

Number Three: Home ownership was the American dream only to the extent that housing protected Americans from monetary inflation. Presidential candidates this year will wax ad nauseam that home ownership is the American Dream and that this dream is now too expensive for average Americans. What they won't talk about is how government policies, and specifically monetary policies, help bring this situation about.

What is rarely asked is why home ownership ever became the American Dream. The dream was never so much to own a home for the sake of it. Rather, the real dream has always been to protect wealth from the evils of inflation, and the middle-class housing market generally served that purpose. Housing was the middle class's best hedge against a growing government intent on expanding its scope and power by inflating the money supply.

Today, housing looks like a relatively weaker hedge, and if this trend continues, middle-class wage earners will have to find better assets in which to store the brunt of their wealth.

In other words inflation has been omnipresent for a while, but homeowners have been sharing in it and thus its full bane has been blunted. Now, the declining housing market will unmask the villain for all to see.

Lastly, why am I so bearish on the bond?

Here's part of a comment I left on another blog.

How do I know the bond is toast?

Look at it this way, the housing boom brought homeownership (or home indebtedness) up to 69%. Essentially, it made the whole country long the bond. When the public piles into an asset, a reversal always follows.



So there you have it. Higher long term interest rates are bad for real estate prices, bad for consumers, and inflationary. Oh yeah, they are bad for all debt-laden governments as well.

Long the long bond....it's a very crowded trade. It's something you definitely should diversify away from.