WHY RISING BOND YIELDS MAY BE HELPING THE HOUSING MARKET BY CREATING A NEW URGENCY TO BUY -- FOREIGN TIGHTENING IS ALSO PUSHING US BOND YIELDS HIGHER AND PRICES LOWER -- FALLING BOND PRICES CONTINUE TO FUEL STOCK RALLY
PENDING SALES OF EXISTING HOMES RISES FOR THIRD MONTH... It was recently reported that home sales for 2010 were the lowest on record. It was also reported, however, that those sales jumped sharply near year end. It was further reported today that pending sales of existing U.S. homes rose in December for the third month in a row and exceeded expectations. I've written several articles showing the bullish upturn that took place in homebuilding stocks during the fourth quarter. Chart 1 shows the DJ US Home Construction iShares (ITB) breaking through its summer highs during December and exceeding its 200-day moving average. Its relative strength line (below chart) turned up around Thanksgiving. My investment philosophy is that strong chart action in any industry group or sector is an early sign that fundamentals are starting to turn more positive for that group. So it's not surprising to read that home sales picked up during the fourth quarter. To what can we attribute those more recent signs of improvement? Part of it may certainly be a more optimistic attitude on the economy and a rising stock market. Here's another possibility that sounds counter-intuitive. Rising bond yields may be boosting home purchases.
(click to view a live version of this chart)
Chart 1
RISING RATES CREATES SENSE OF URGENCY... One of the commonly held beliefs is that rising bond yields are bad for housing. That's generally true when rates rise enough to choke off mortgage demand. But rising rates can actually help housing when they first turn up. It has to do with a deflationary versus an inflationary psychology. A deflationary environment discourages purchases. Why buy a house, for example, when prices are still falling? You can always wait for a better deal. The price of a house, however, is only part of the cost. The interest rate you pay on a home mortgage is also important. As long as they're falling as well, there's no urgency to buy. When mortgage rates start rising, however, that creates more urgency. That creates an inflation psychology. In other words, lock in a mortgage now before rates get even higher. I believe that may now be happening and may help explain recent signs that home purchases are picking up. Chart 2 overlays the yield on the 30-Year Treasury Note (green line) to the homebuilding index. It's very clear that the bottom in bond yields in late August coincided exactly with the bottom in the ITB. The upturn in the ITB:SPX ratio occurred in early December when the long bond yield exceeded its November high and confirmed that bond yields had bottomed. That's also when a lot of the new home buying started. Since mortgage rates are tied to bond yields, rising bond yields make it more expensive to buy a house. As a result, a greater sense of urgency to buy (a new inflationary psychgology) may be starting to build in the housing market.
(click to view a live version of this chart)
Chart 2
WHICH MEASURE OF INFLATION IS BEST... A debate is taking place in financial circles about how to measure the current rate of inflation. The Fed argues for core inflation (which excludes food and energy) as the best way to measure underlying inflation. Others (including foreign central banks) include food and energy in their inflation calculations. And for good reason. Chart 3 shows agriculture and energy prices surging. Surging food prices are raising alarms in a lot of foreign countries. Chart 3 shows that the bottom in the US long bond yield (green line) coincided close with a bottom in energy prices (black line). A lot of people argue that rising food and energy prices are a truer measure of rising inflation pressures. Bond holders appear to fall into that latter group which helps explain why they're been selling their bond holdings over the last few months.
(click to view a live version of this chart)
Chart 3
CHINA AND INDIA ARE ALREADY TIGHTENING ... It's never a good idea to ignore foreign influences when looking at U.S. interest rates. Chart 4 shows why. Two major foreign markets that have raised interest rates several times to combat the threat of rising food and energy prices are China and India. And their stock markets have suffered as a result. Chart 4 shows Chinese stocks (red line) and India peaking together during November. It's no coincidence that the price of the 10-Year T-Note (green line) peaked at the exact same time. [Ten-year prices and yields are used for international comparisons]. Clearly, rising inflation pressures owing to surging commodity prices are causing foreign rates to rise in large emerging markets. Even the European central bank has stated that it's prepared to act to stem rising inflation pressures. That could lead to higher rates in Europe. One side effect of rising rates abroad would be to weaken the dollar. That in turn would lead to even more inflation in the U.S. That would be even worse for U.S. bond holders.
(click to view a live version of this chart)
Chart 4
FALLING BOND PRICES ARE GOOD FOR STOCKS... Arthur Hill has been reporting on the bearish price patterns for Treasury bond ETFs. The hardest hit has been the 20+year T-Bond iShares (TLT) shown in Chart 5. [The long Treasury is the most sensitive to rising inflation expectations]. It's no secret that bond money is moving into stocks and commodities. Chart 5 shows the Labor Day bottom in the S&P 500 (green line) conciding exactly when the peak on in the Treasury price. Since then, falling bond prices have coincided with rising stocks and commodities (bottom line). That's what happens in a more inflationary environment. Rising commodity prices are also indicative of economic strength (greater demand). Rising inflation also allows companies to pass along some of their own price increases which benefits their bottom line. Unfortunately, the main side effect of rising inflation is rising interest rates which is bad for bond prices (which fall when yields rise). Falling bond prices are causing a lot more money to flee bonds for stocks. I expect that stock prices will continue rising for as long as bond prices keep falling. I further expect that rising bond yields will contribute to an improving housing sector by creating a more inflationary urgency to buy homes. And should help keep any stock market pullbacks relatively shallow.
