James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

If housing is the primary force behind the U.S. economic cycle, then the recession early warning bells just started ringing.

Sales of new single-family homes recorded a shocking fall in February, tumbling by 16.9 percent, to a seasonally adjusted 250,000 annual rate, hitting the lowest such figures since records began in 1963.

New home sales are down 28 percent compared to a year ago and the inventory of unsold new homes is now equal to 8.9 months of sales.

Even more amazingly, in a nation with more than 110 million households, there were just 19,000 single family home sales for the month on a raw unadjusted basis.

Put simply, far from being an engine of growth after several years of contraction, investment in housing looks to be a drag on the economy in 2011.

“We continue to believe that this dip in housing will translate into a double dip on the overall U.S. economy, further rolling forward any stimulus-exit plans set by the Fed, and setting the stage for an announcement of QE3 in July,” said said Douglas Borthwick of Faros Trading. “Jobs and housing remain the focus for the Fed, and both areas continue to face severe difficulties.”

The problems lie not just with new homes. The overall picture is of a housing market slouching its way into a double-dip slump.

Sales of existing homes also fell last month, by a less precipitous 9.6 percent, down 2.8 percent from a year ago.

Prices of existing homes, unsurprisingly, are falling as well, down 0.3 percent in January nationwide, according to the FHFA, the third straight monthly fall.

The number of properties in foreclosure hit a record 2.2 million in January, according to Lender Processing Services, while something on the order of one-in-five homeowners with a mortgage are in negative equity, with mortgage debt exceeding the value of the house. In Florida 20 percent of dwellings stand empty, a statistic implying not just a few quarters of slump in building but several years.

This matters to the economy in two important ways. Firstly, housing activity, from building to buying to outfitting, is one of the prime drivers of the economic cycle. Secondly, if a slump is deep and protracted the bad debts it will produce will once again threaten to capsize the banking system.

NINE OUT OF ELEVEN IS NOT BAD

At a paper delivered at the central banking conference in Jackson Hole, Wyoming, in 2007 entitled “Housing IS the business cycle”, UCLA professor Edward Leamer argued that residential investment plays a key role in US recessions. He demonstrated that 8 out of 10 postwar recessions were foreshadowed by serious and sustained problems with housing, at least as of 2007.

Counting the most recent recession we can now call that 9 out of 11, with a good shot shortly at 10 out of 12.

“Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession,” Leamer wrote.

“After a surge of building there has to be a time-out… before building can get back to normal, and before this channel through which monetary policy affects the real economy is operative again. The Fed can stimulate now, or later, but not both.”

Of course the Fed, as has been its way since the Greenspan era, has tried to eat the same cake repeatedly, but the recent run of data shows that the housing market is not responding.

Efforts at foreclosure mitigation have been a failure as well, with a small success rate and a high probability of re-default.

You could argue that efforts to prop up the housing market, from loan modification to tax incentives, have only served to lengthen the time that the fall of house prices takes, prolonging at the same time the “time-out” in construction and allied activity.

It will also be interesting to see just how well the banking system weathers a second fall in house prices. Much of their portfolios of loans and loan-derived securities are being carried on bank books at what may turn out to be optimistic levels.

If another wave of defaults comes, the truth of cash flows may well expose those marks for the fantasies they are. In this light the U.S. Treasury Department’s decision this week to allow many large banks to raise or recommence dividends may prove to be a mistake.

To be sure, U.S. manufacturing is doing well, and demand from emerging markets, particularly for natural resources and other commodities, will help to counteract the drag that housing will have on the economy.

Perhaps the scariest aspect is this: another housing bailout is probably politically impossible. This time the chips really will fall where they may.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

We’ve entered a new era in global financial markets: the U.S. is intentionally devaluing the dollar.

For the U.S., which has long espoused a strong dollar but in reality had a policy of benign neglect, this is the equivalent of pushing the big red eject button in the jet cockpit: something big is going to happen and we will have to see how it will work out.
The Federal Reserve on Wednesday moved to open a second round of quantitative easing, pledging to purchase a total of $600 billion of longer-dated Treasuries between now and the end of the second quarter of next year. As well, the Fed will reinvest $250-300 billion in the same period, meaning that the central bank will be buying up $110 billion a month in Treasuries and creating a like amount of new money out of the ether.

Perhaps the principal way QE will boost the economy, the Fed hopes, is by lowering effective interest rates, enticing investors to move into riskier assets, some of which may generate inflation and jobs. As well there is the wealth effect; the old canard of spending more because your retirement account and house have gone up in nominal terms.

The bald fact, though, is that by turning on the printing presses the Fed will drive down the value of the dollar absent a similar move in another currency. Much of the new investment created by QE will be made not in the U.S. but will be money borrowed in the U.S., exchanged into a foreign currency, probably an emerging markets one, and invested overseas. That will drive the dollar down, which will help to make U.S. industry more competitive.

There you have it; competitive devaluation, a beggar-thy-neighbor policy. It is not much of a lever, but it is one of the few which the Fed has left to pull.

Don’t expect anyone from the Fed or the Treasury to tell you this in simple declarative sentences, but it’s true nonetheless.

“Devaluation is the intention, and devaluation is what is going to happen,” Avinash Persaud, Chairman of Elara Capital told the Forex Forum conference in New York on Tuesday.

We can surely expect the U.S. to deny this, as Treasury Secretary Timothy Geithner did in October, but the truth will be seen in the foreign exchange markets, where the dollar has been falling and will fall further as the year winds down.

GETTING THE GENIE BACK INTO THE BOTTLE

It is most certainly in the power of the U.S. to begin a period of competitive devaluation. The U.S. dollar is a global reserve currency and the marginal cost to Bernanke of printing more is very low indeed. Less certain are the reactions of the rest of the world.

While the U.S. will surely have prepared the way for QE2 with its major trading partners (and in fact may be deliberately ticking off the Chinese) there remains a strong chance that a falling dollar sets off a range of tit-for-tat reactions. Already Korea and Brazil are moving to stem the appreciation of their own currency. Look too for the possibility of other countries joining in to QE, in part so that the Japanese yen, to name just one, does not rise too much against the dollar.

A currency war blossoming into a trade war has to be one of the outside but significant risks of 2011. If global growth can recover significantly this may be averted, but this is far from promised.

The second and maybe more important risk is that the U.S., having lost control over its own monetary policy many years ago due to recycling of capital by the Chinese, now loses control of its currency. Like going broke, this can happen little by little and then all of a sudden.

On the Fed’s reckoning it will go like this; QE2 and very low rates go on for an extended period, but almost as a matter of mechanics, when the Fed begins to tighten, the dollar recovers. The Fed has used the dollar lever to ease and then uses it to help to tighten. The dollar remains the principal global reserve currency and investors respond to the Fed’s incentives.

The alternative is that QE is not terribly successful in improving U.S. growth but does touch off a round of speculative investment elsewhere, investments that make returns in a shrinking dollar look worse day by day. When the time comes that the Fed, perhaps hurrying to prove its control, decides to stop QE2, bond investors want compensation for holding U.S. debt — a lot of compensation. U.S. equities, which have been held aloft by QE, duly fall sharply, as does the dollar, while yields spike. This is not a central case, but it is a possibility, and as it would be a disaster, one that needs to be watched closely.

Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.