US property bubble: No longer safe as houses
A punctured US property bubble is not far down the line as inflationary pressures mount. When it comes, as treasury yields inevitably move up, the US economy will slow sharply
In the past year, the housing bubbles of the UK and Australia have burst. House price growth in both countries has plummeted from more than 20% a year to zero. The effect on the two economies has been different. In Australia, economic growth has motored on; in the UK there has been a sharp fall-off in consumer spending and thus in real GDP expansion. The UK could even slip into recession in the next year.
The reason for the different outcomes is clear. Australia has continued to expand on the back of massive demand from China for industrial metals and raw materials. In the UK, the collapse of the housing market has doused the main driving force of growth: consumer spending.
There is still one great property bubble left: that in the US. House price rises are racing along at 13% to 15% a year. The "measured pace" of interest-rate increases by the US Federal Reserve has not cooled the real estate sector. This is because mortgage rates in the US are tied to US treasury yields, not to short-term bank rates as they are in the UK and Australia. And US long bond yields have not moved up. Fed chairman Alan Greenspan's conundrum persists.
However, I reckon the US housing bubble will end in even more tears than have been shed in the UK so far. The likeliest outcome is that continued strength in the US economy will tighten supply and demand for everything from labour and capital to commodities so much that it will push inflation to a level that spooks the bond market.
But it's also possible that the housing market will collapse under its own weight before long bond rates do the trick, as house prices rise beyond the means of most American households.
Since US mortgage rates are priced off treasury bonds, the property market continues to glow red-hot. And these are just standard variable rates charged to consumers. Zero-financing or negative amortisation mortgage incentives lower the effective interest rate even more.
Indeed, the latest household survey indicates that commercial banks are making it easier for consumers to get credit. There's never been a better time for Americans to ask their bank managers for loans.
On top of this, job prospects are improving. With household income and wealth growing so well, American consumers have every incentive to keep spending.
But this is the lull before the storm. Beneath a calm surface, I reckon inflationary pressures are building. Excess output capacity has now disappeared, productivity growth continues to slow and unit labour costs are rising. Along with the oil price shock, US inflation is set to accelerate. That will push up long bond yields and end the housing bubble as the cost of financing purchases becomes unaffordable.
Even if that does not happen soon, the housing market bubble could burst anyway. Housing affordability has already been stretched to the limit, especially in the coastal cities.
I recently tested the strength of housing stress in the US, using the National Association of Realtors affordability index. The NAR index has started to indicate a sharp fall in nationwide housing affordability, as a result of house prices outstripping average household income growth.
What would have to happen to take the index into unaffordable territory and thus kill the housing boom? I found that, if I assume the status quo (that household income and house price growth are maintained at their current rates, but with no rise in the mortgage rate), America's average home will not be unaffordable to the average homeowner until June 2007. That's still nearly two years away.
However, if I assume house price and income growth are maintained at their current rates, but mortgage rates rise just
50 basis points over the next 12 months, housing will probably become unaffordable as early as spring 2006. That's because house prices will have reached extremes that cannot be sustained.
So a big rise in the mortgage rate is not necessary to pop the US housing bubble. Rapidly rising house prices are doing the job themselves. Just a 5% 10-year treasury yield will do the trick. And such a yield is very likely before the end of this year.
That's why I reckon the housing boom will be over by next spring and the US economy will slow sharply. Get ready for the bursting of the last great property bubble.