General

Could housing crack before inflation does? – Financial Times

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Good morning. Last week ended up being the strongest for stocks since late 2020. Feeling reassured? Today, one big pitfall of rising rates and the little-aired bear case for oil. Email us: Robert.Armstrong@ft.com and Ethan.Wu@ft.com.

Rising rates and housing markets

Markets were pleased with the Federal Reserve’s interest rate hike last week. But how far can the Fed go? Here is a scary prediction from Bill Gross, the erstwhile bond king:

The founder of investment house Pimco told the Financial Times this week he believes inflation is approaching troubling levels but the US central bank will not be able to implement higher policy rates to contain it.

“I suspect you can’t get above 2.5 to 3 per cent before you crack the economy again,” [Gross] said. “We’ve just gotten used to lower and lower rates and anything much higher will break the housing market.”

Singling out housing makes sense. As we’ve discussed, house prices and rents are very high. Roaring demand, driven partly by demographics, is paired with meagre supply. The inventory of existing homes for sale hit an all-time low in January and has hardly recovered. Homebuilders are rushing to get fresh inventory on the market, but are constrained by shortages of labour and building materials.

The best fix would be building more homes. Until then, higher rates are bound to cause problems. Chunkier mortgage payments will limit demand, but also encourage homeowners to cling on to their current, cheap mortgages. That will further limit the supply of existing homes, notes Aneta Markowska of Jefferies.

Though the Fed has only started tightening, mortgage rates weren’t inclined to wait for the starter pistol, kicking off a fierce climb in late December:

The impact on the market is already evident. February data from the National Association of Realtors found existing-home sales falling 7 per cent month-on-month. Here’s NAR’s head economist, Lawrence Yun, on Friday:

Housing affordability continues to be a major challenge, as buyers are getting a double whammy: rising mortgage rates and sustained price increases. Some who had previously qualified at a 3 per cent mortgage rate are no longer able to buy at the 4 per cent rate.

Monthly payments have risen by 28 per cent from one year ago — which interestingly is not a part of the consumer price index — and the market remains swift with multiple offers still being recorded on most properties.

Strategas’s Don Rissmiller and Brandon Fontaine point out that policy rates around 1-2 per cent were enough to clip housing demand in 2018-19. The median Fed projection is right in that range, around 1.9 per cent by the end of the year. This time around, though, consumer debt is higher. Mortgage debt as a share of real GDP has risen 6 percentage points to 55 per cent, since the last rate-hiking cycle peaked in late 2018.

If history repeats, stumbling house demand could show up as weaker output growth. Ian Shepherdson of Pantheon Macro explains the mechanics well:

A sustained drop in home sales — new home sales will fall too — would be a direct drag on GDP growth, at the margin, via downward pressure on residential investment, and all the services — legal, removals, and others — directly tied to sales volumes. It would also depress retail spending on building materials, appliances, and household electronics.

The nightmare scenario is that the Fed ends up with an inverse Goldilocks situation: rates high enough to hurt growth through the housing market, but too low to get inflation under control. This is far from guaranteed. US fundamentals could prove sturdy enough to support housing demand. But Gross’s warning is important. As rates rise, watch housing. (Ethan Wu)

A lonely oil bear

Most people think, with reason, that oil is going to be expensive for a while. Russia is at war and faces tightening sanctions. Global demand is strong. And both the big US producers and the Opec countries are demonstrating some production discipline, despite prices rising from $75 to over $100 this year.

Ed Morse, head of the commodities team at Citi, stands well outside this consensus. How far outside? Here are his price projections compared to the prices implied by the futures market:

Column chart of Projected crude oil prices, $/barrel showing Transitory!

If Morse turns out to be right, it will matter far beyond oil markets. Oil near $60 later this year might be enough to slow the expected upward march of interest rates, with significant effects on prices all across markets. And Morse has made correct contrarian calls in the past, proving prescient about the 2008 and 2014 price collapses.

Morse’s laid out his bearish view for me on Friday. It rests on 4 main planks:

Current high demand is evidence of a recovery, not secular strength in the economy. “We think the demand surge is a return to normal after a deep recession rather than a precursor of sustained demand,” Morse says. “Gas and oil demand did not move very much between 2015 in 2019, despite some increases in emerging markets, because of developed markets and China.” Morse points out that the Chinese do not tend to use cars for long-haul travel, and like electric vehicles, explaining the low oil intensity of China’s growth. He expects this to continue. Overall, Morse thinks that the hydrocarbon-intensity of the global economy is declining in a straight line, in developed and emerging markets alike. Nothing can stop that trend for long. The only oil markets where he sees rising demand in the long term are jet fuel and petrochemical feedstock.

My brilliant colleague Derek Brower (nb: he made me write that) of FT’s Energy Source newsletter (it actually is pretty good, sign up here) thinks that Morse may be on to something here with his China point. “Barrel counters say Chinese demand is already looking a bit toppy, especially at $100-plus oil . . . that said, hunting for the peak in Chinese oil demand has been something of a Moby-Dick endeavour in recent years, and we’ve seen false signs of it before.”

The war in Russia is unlikely to disrupt supply as much as the markets expect. “What we are seeing is self-imposed restrictions [on buying Russian oil]. Some people, even in government, think that because of these restrictions exports are about to tumble. And it is true that auctions are shutting down. But if you look at ship loadings, there are buyers. We know there is enough lifting [tanker-filling] capacity there.” Morse believes, in short, that the market is not cynical enough about Russian oil, which is selling at a $30 discount, finding its way to market one way or another.

Russian production is indeed rising, for now. Much will depend on how hard the US and other western nations are willing to squeeze. If sanctions persist, the departure of global capital and expertise will start to degrade Russian capacity, too; but that is a long-term issue.

US shale fields are going to produce more than the market expects. “In US shale we have an accelerating rate of rig utilisation — we have private sector companies going all out for drill baby drill,” he says, waving away the common refrain that the big publicly traded US producers, such as Pioneer and Devon, prefer higher returns to higher production. Sixty per cent of new drilling is at private companies funded by private equity, he says. PE sponsors, having suffered through some hard times, are eager to get out of the business, and the best way to do that is to quickly push their projects to the high cash flow stage, and then sell them to larger producers.

Nor does Morse buy the argument the labour and equipment supplies limit production growth in the US. “There is a good 100 high-quality rigs available. There are good fracking crews available. If they need manpower, they’ve just got to pay more”. At the same time, the productivity of each well is increasing.

Line chart of North American drill rig count showing Drill while the drilling is good

Producers around the world are responding to higher prices with production. Canada, Guyana, Brazil, Argentina and even Venezuela are signalling increased output. And then there is the possibility that Iran returns to the market later in the year.

Morse is a voice in the wilderness for now. But as we have learned repeatedly recently, at this weird moment, it is crucial to listen to dissenters.

One good read

In his first official FT column, Stephen Bush asks how the UK can create an immigration policy that isn’t actively terrible.

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