Home Prices to Level Off and Reverse Course Within 2 Years – Analysts

Two Bank of America Merrill Lynch (BAML) analysts are defendingrnwhat they call their big high conviction views for what should happen in thernhousing world over the next two years.   rnChris Flanagan and Gregory Fitter, ABS and MBS strategists say thatrntheir views are not mainstream but that recent data has corroborated theirrntheories.  </p

Therntwo contend that home price increases will continue to moderate from thernskyrocket trajectory they were on in late 2012 and early 2013 will peak inrnmid-2016.  Second, as unemployment continues to ease,rnthe yield curve will continue to flatten (longer term rates getting lower while shorter term rates get higher, relative to each other) and the spread between two year and 10rnyear treasury yields should be at zero by the time home prices peak.  The long end of the curve will remain atrnsurprising low yields, fostered by a soft housing market and low inflation.  </p

Thernfirst “big view”, that home prices will peak in two years is validated they sayrnby the most recent income based home price model from Case Shiller.  Charts 1 and 2 includes the Case Shillerrnhistorical and forecasted home price index (HPI) along with the BoArnstrategists’ estimate of fair value. rnThis model shows that the HPI will increase from the first quarter 2014rnlevel of 155.5 to a peak of 167.3 in the third quarter of 2016.  This is an annualized growth of 3 percentrnover 30 months compared to 11 percent in 2013 and the 9.5 percent annualizedrnrate since prices bottomed in the fourth quarter of 2011. Then prices arernexpected to decline and not recover to the 2016 level until Q2 2022, anrnannualized rate of price growth over six years of 0.  With this factored in, the annualized homernprice growth rate between Q1 2014 and Q2 2022 is expected to be 1.0 percent.</p

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Thernauthors estimate that the Case-Shiller HPI was already 9.7 percent over valuedrnin the first quarter of this year when compared to the author’s fair valuernestimate and that it was 6.2 percent undervalued when it hit bottom in 2011, arn16 percent swing in valuation in two rnyears.  The last time such a raternof acceleration was observed was in 2002, the beginning of the housingrnbubble.  The author’s model projects thatrnprices will be overvalued by 12 percent late next year or early in 2016 andrnthis will eventually lead prices to fall, probably below fair value. </p

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The projectedrnreversion to fair value mirrors what happened before, during, and after thernhousing crisis, but at a lower level of reevaluation.  During the early 2000s housing boomrnovervaluation peaked in Q1 2006 at 58.9 percent before prices declined by 34rnpercent, overshooting fair value at the bottom end.  It will be very different this time,rnprimarily due to the regulatory framework, most notably Dodd-Frank, which hasrnbeen put in place in response to that boom and bust.  After peaking this time, they expect pricesrnto remain flat or unchanged for six years, not plummet as happened ten yearsrnbefore; exactly what the regulatory framework was meant to do.  “Fromrnthat perspective,” they say, “0% homernprice growth from 2016-2022 seemsrnto usrnto be a fantastic outcome and exactly whatrnpolicymakers had hoped for when establishing the new regulatory framework.”</p

Givenrnthis scenario the authors ask what the catalyst might be for increasingrninterest rates.  If anything, they way,rneven lower rates seem more plausible; “itrnis difficultrnfor us to see whatrngenerates any meaningful, sustainablernincrease in interest raternvolatility.”</p

The authors also cite the May CoreLogic report issued in early July asrnfurther substantiation of their theory of slowing price growth.  CoreLogic, with data more recent than thatrnprovided by Case-Shiller, shows year-over-year (YOY) home price growth for Mayrnof 8.8 percent, down 3 percentage points from February’s 11.8 percent which thernauthors believe will prove to be the cyclical peak.  Annual growth of 11.5 percent had persistedrnsince early 2013.  The decline from thernFebruary “peak” started in March and accelerated to the downside in May.  </p

Likewise, the annualized month-over-month (MOM) data slowed temporarilyrnafter mortgage rates went up in mid-2013 from the 20 percent level early in thernyear.  While January and February 2014 werernexceptionally strong at rates of 26.0 and 16 percent respectively growth then beganrnto slow.  MOM data for May showed anrnincrease of 1.7 percent following 2.4 percent in April.  Flanagan and Fitter said that CoreLogic’srnApril and May readings suggest that their own model calling for a 3 percentrnrate of price growth for 2.5 years followed by 1 percent for the next eightrnyears is beginning to be realized.</p

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Their second view that massive yield curve flattening began with thernnew year and will continue until the 2 and 10 year spreads hit zero in 2016 isrnbolstered by the most recent unemployment report.  Chart 4 shows their view of the relationshiprnbetween unemployment and the two yield curve spreads.  The unemployment rate has been declining in arnfairly linear manner since the peak in October 2009.  Extrapolating the decline forward, theyrnestimate that unemployment will hit 5 percent in 2015 and 4 percent in earlyrn2017.  Historically it has not been longrnafter unemployment drops below 5 percent that the 2 and 10 year spreadsrnapproach or drop below zero.</p

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The analysts concede Fed Chairperson Janet Yellen’s concerns aboutrnlabor market slack could mean it will be different this time, but they hold torntheir theory; that declining unemployment will force the Fed to act and thosernzero rates will be obtained on the schedule they project.

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