Real Estate
With accelerating inflation, an inverted yield curve, and the Fed poised to raise rates, expect a recession and a slump in Arizona real estate
Real estate prices and activity are poised to head even lower, as it is now clear that the U.S. is likely headed to a recession. Two major indicators have emerged in the past week that make this highly likely.
First, an 8.6% CPI inflation rate, a 41-year high, was reported by the Bureau of Labor Statistics (BLS) on Friday, June 10. This exceeded the prior high report of 8.5% in the April report. This can be seen in the chart below.
This shows that inflation is basically accelerating. In fact, the last three months have shown higher inflation on an annualized basis, than the 8.6% rate.
Here is why. The monthly rate of inflation in May was 1.0%. The rate in April was lower at 0.3%, but the March rate was 1.2%. So these three add up to a quarterly rate of 2.5%. On an annual basis, that means inflation is now actually running at 10% on a run-rate basis.
In fact, if the 1.0% monthly rate stays level, the monthly rate will turn into 12% (before compounding).
If inflation actually rises to between 10% and 12%, markets will enter into a shock period. The Fed will be forced into slowing down the economy by initiating surprise rate increases and other efforts to drain cash out of the economy.
However, let’s not get too fearful. For one, look carefully at the chart above. The gray line below the red line shows the prior 12 months’ inflation rate. It shows a recent upturn. In other words, we are now starting to lap the beginnings of inflation increases. So within a few months, the actual rate of inflation, or price rises, will ameliorate, since the price levels from a prior 12-month period will already be high.
That is, only if inflation expectations don’t continue. This is where the Fed comes in. As their rate hikes start to slow economic activity, then inflationary expectations will lower the level of prices. Otherwise, inflation levels will continue accelerating.
But now that brings up another problem. The US treasury rate curve has now turned negative. This often indicates a recession is coming.
Here is what that means. Look at the following chart:
It shows that the 30-year and 10-year yields are actually lower than the 5-year yields from the WSJ’s bond data page. This information is publically available from numerous sources as it reflects the market prices of these bonds. The “curve” is from charts like this below that shows time to maturity (bond year length) on the horizontal line and yield on the vertical axis.
Note that this is the opposite of what normally occurs. Normally the Treasury department has to offer higher investment yields (and the market reflects this in the secondary market) in order to tie up your money longer.
So the normal 10-year yield is higher than the 5-year yield. Now that relationship or curve is inverted. The yield-to-maturity is 3.227% (annually) if you buy a 5- year Treasury bond. But if you buy a 10-year bond, you only make 3.163% annually.
That implies that investors loathe the prospect of tieing up their month too long. They don’t want inflation to kill their purchasing power. Moreover, they also expect that the economy will falter and rates will fall in the future.
This can become a severe problem if the 2-year yield, now at 3.069%, overtakes the 10-year rate. That will indicate a severely inverted curve and signal that investors are highly negative about their outlook for both inflation and economic growth.
Note how close the 2-year rate is to the 3.163% rate. They both are over 3.0% and indicate that investors are almost complacent about owning a 2-year vs. a 10-year bond. In other words, they don’t want to get stuck in a long-term investment. They are scared.
These two signals — accelerating inflation and an inverted yield curve — should send shudders through the real estate market participants. This is close to what happened in the early 1980s when Paul Volker instituted shock rate increases in both the Fed Funds Rate and the Fed discount rate in order to kill inflationary expectations. As a result, the economy hit a major recession.
A similar event could easily happen soon. The Fed is scheduled to meet this week. The market already has priced in a 50 basis increase in the Fed Funds rate for the next three months. But that may not be enough. The market may invert the yield curve even further to force the Fed to eliminate inflationary expectations.
This will raise the base rates that most mortgages are priced on. The result will be that real estate investors and market participants can expect much higher rates going forward.
That will also lead to follow-on ramifications: lower new home sales, lower average selling prices, dramatically lower high-end sales, and possibly even higher mortgage defaults. The latter will depend on the high rates rise, how hard the Fed works to slow the economy, and how hard and long the recession will last.
One more thing. Remember the gray line above. Even if inflation starts to slow down within the next several months, this does not mean that price levels will fall. High price levels may take a long time to fall, depending on inflationary expectations. That will keep mortgage rates high. And that will have a deleterious effect on the real estate market.
The bottom line here: expect a recession, expect higher rates across the board, and expect lower real estate activity.
For example, recently the Phoenix, Arizona real estate market has started to cool off. A well-known index called the Cromford Report Market Index is now at 240.8 as of June 10. This is down significantly from the mid-to-high 300s and low 400s just a month or so ago. A level of 100 indicates that there is an equilibrium between buy and seller forces.
In fact, several commentators (e.g. Rick McHone, and Caitlin McKeague) on YouTube have pointed out that the Cromford Report said that this was the fastest decline in real estate activity on an index basis (measuring buying and selling forces) they have ever seen.
So given these indicators, and the recent cooling in the Arizona real estate market, expect that a recession will significantly slow Arizona real estate activity going forward.