Last week, the yield on 3-month treasuries dipped below the yield on 10-year treasuries. The last time this “yield inversion” happened was late 2007, and it preceded the worst U.S. recession – and the worst housing market — in a generation. Is history repeating itself? Statistically speaking, it’s pretty unlikely. And while an inverted yield curve has a good track record for predicting recessions, the implications for the housing market are much less predictable.
To review, during “normal” times, short-term government bond yields are less than longer term bond yields. This “yield curve” is usually upward sloping as bond investors receive higher rates as the terms of gov’t bonds increase. That’s because the perceived risk in a longer-term environment is higher. Long-term bondholders are exposed to inflation and interest rate risks, so they demand greater compensation.
But on rare occasions, the relationship between short- and long-term gov’t rates inverts. When this happens, it’s a signal that growth expectations are waning. If bond investors believe the economy is slowing, they begin anticipating that the Federal Reserve will lower interest rates to prop-up growth. So, investors buy longer term gov’t bonds, locking in yields before they go lower. Meanwhile, the demand for low yielding, short-term bonds is low, so those yields tend to firm up to attract investors. An inverted yield curve is a barometer of negative economic sentiment.
Yield inversions do have a good track record of forecasting recessions. From the New York Fed’s website:
“The yield curve has predicted essentially every U.S. recession since 1950 with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967.”
If history is a guide, a recession is a few months to two years away. The New York Fed puts the current probability of a recession looking out one year at about 25%.
Treasury yields since September:
However, there is considerable opinion among economists that “this time is different.” For instance, RBC’s chief US economist, Tom Porcelli, argues that last week’s yield-curve inversion does not follow the historical pattern in which domestic investors drive down long-term rates over fears of short-term economic turbulence. Instead, Porcelli says the long end of the curve has been driven by global growth fears while US economic growth remains relatively robust.
“The problem with the current inversion and the historical record is that the yield curve at present is not a referendum on the path of economic growth in the United States, but rather a function of goings on globally,” Porcelli wrote.
In any case, we are in the Real Estate lending business, and as such our primary focus are the U.S. housing markets. And the implications of an inverted yield curve for housing is far from clear.
Historically, recessions have not necessarily meant bad things for the housing market. In fact, they usually don’t. We discussed this, a la Robert Shiller’s research, in another investor letter recently.
ATTOM Data Solutions looked at home prices during the five recessions since 1980 and found that only twice — in 1990 and 2008 — did home prices fall during the recession. And in 1990 it was by less than a percent. During the other three, prices actually went up.
“Housing is such a basic need that it won’t necessarily do well, but [it will] at least truck along,” said ATTOM’s Daren Blomquist. “It may flatten out a bit, but people still need somewhere to live, so that basic need is going to cause the housing market — and particularly home prices — to continue to go up.”
From our perspective at Aloha Capital, the underpinnings of the housing market remain stable: Housing supply continues to be tight across the country, as home builders have been slow to produce. At the same time, the strong economy coupled with a millennial generation coming of age has added new demand to the housing market. Low supply and high demand, eventually, yet also intermittently, means higher prices.
For a recession to impact the housing market in an adverse material way, it will need to fundamentally alter the dynamic between supply and demand. A spike in unemployment could negatively impact demand, or an out-sized move in interest rates. However, with unemployment unusually low, it should take a fairly dramatic rise to cause home prices to drop significantly. And mortgage rates have been falling again, since the Fed signaled its pause due to the–well–potential recession on the horizon as foretold by the yield curve inversion!
Ask any economist, they’ll likely agree that predicting economic activity and/or oncoming recessions out past a year is difficult, like predicting next month’s weather. But even if the yield curve inversion does lead to a recession down the road, there’s a decent chance the impacts on housing, and particularly the less volatile housing markets, will be somewhat limited.
The Fund has begun 2019 with a move back toward its historical norms of monthly performance.
As always, feel free to reach out with questions and interest in working with Aloha Capital in this excellent investment–Aloha LTD Income Fund.