Home Supply Forecast (via New Home Sales)

Here is a long run look at population divided by number of annual home sales. From 1963 to 1995, there was a mean of 383.27 people in the US population per each new home built. Starting in 1995, the number dropped from 394 people per home to a record 229 people per home in 2005 (the building peak).

Assuming this population per production # is mean reverting, and the extra new housing supply was borrowed from future demand, it can be easily forecasted how much was overbuilt starting in 1996 and how long it will take for long run oversupply to return back to zero. This model establishes that new housing sales continue at the 2010 current average rate of 322K/year, and the US population grows 3 million people per year going forward. A netting out of long run oversupply does not occur until 2013. After 2013, new home sales should run at population divided by 383.27, assuming long run averages hold, or approximately 840K builds and sales per year at 2014.

These numbers generally concur with the yield curve forecasting a meaningful recovery starting in 2013-2014, as housing supply returns to long run balance.

Thoughts on Housing

Browse the web for today's financial news of "Existing home sales plunge 27%" and you'd think the world is ending.

It's not. This is simply a drop-off in transaction volume, and the news has already been telegraphed by falling agency debt rates. Average home prices are still 10% above 2010 lows, and just as in stocks, a fall-off in trading volumes do not mean the same thing as a price crash.

Common knowledge says tax credits catalyzed buyers to come out of the woodwork and move up the time-frame of purchase, borrowing future trading volumes into present periods. And as home transactions take longer and are done in much rarer frequency, it is likely volumes will remain anemic until enough time passes for the number of buyers to naturally replenish.

Granted, quantity traded is generally smaller on a higher price, so the volume numbers could be interpreted to convey lower prices lie ahead as the market re-equilibriates down in a post-tax-credit environment.

But expected returns on assets are in a nosedive, lending some countervailing support to asset prices. While 30 year treasury debt yields 3.57%, in local formerly overheated housing markets such as San Diego, even without being lucky enough to steal a discounted REO, one can easily buy entry level (under $200K) rental properties that yield 6-8% after expenses. In the mid range ($400-600K), yields hover closer to 4.5%-5%. It would make sense that these price ranges experience converging rental yields. On an indexed basis, a fall of the mid-ranged sectors may bring median prices down substantially, even if the low end strengthens (or holds up) considerably from here. In the face of a long run excess return of 350-400 basis points over treasuries with the added benefit of the asset being tangible and physically impervious to central bank monetary policy whims, the considerable value already in today's housing market can not be forgotten.

Given where risk-free yields are, there is no shortage of capital out there, and longer term arbitrage will continue to evolve all of these markets in better balance. Artificially higher pre-credit-expiration trading volumes in housing (almost an extra million units/year on an annualized basis) followed by a drop-off of similar magnitude (about minus a million units/year annualized) make sense. Given volumes were substantially elevated above norm for 3 months (September to November) out of 2009 and another 3 out of 2010 (March to May), it would make sense that we have up to 6 months (starting in July) of anemic volumes until normal trading demand returns. January 2011 should likely bring a return to the annual 5 million unit resale run rate.

Until then, lower than average agency debt supply (given that borrowers will have below-normal demand for new mortgages) combined with deflationary excitement means lower mortgage yields. Perhaps a 3.5% or 4% mortgage, provided by natural market forces, will be the perfect catalyst for the early round of 2011 home buyers.

Treasury Yield Curve Implications

Here is a derivation of implied 1 year forward rates on treasuries. A 1 year treasury forward is close enough (for government work) to get an idea of when the market projects the Fed will start moving rates upward. If you imply the Fed responds with hikes because a recovery is already happening, this data tells a little more where general sentiment is at.

For the sake of robustness, I purposefully designed this to work with very few input points, necessitating a basic a smoothing mechanism. From this, there is a small amount of error, but nothing meaningful.

The obvious interpretation here is that the treasury markets as of today do not project a meaningful recovery will start until 2012, with the end of cycle not happening until 2017. Post 2017, I'll venture to say 25 basis points of 1 year treasury forward movement per year is not actually projected Fed Funds policy change, but instead accounting for normal upward sloping yield curve behavior, where investors want to be paid extra for taking more interest rate risk from longer duration bonds.

The same analysis from a US treasury yield curve from November 1st, 2006: