Why an end to the housing bubble may lead to recession

Bill Gross, the managing director of global bond manager PIMCO, has laid out a likely timetable for an end to the housing bubble, followed by a weakening economy leading to possible recession in the US and elsewhere from next year. download report…

In his latest Investment Outlook for clients, Gross (often referred to as the Warren Buffet of bonds) says the “almost inevitable, 99 per cent unavoidable” sequence of events is: 1) Housing prices will cool/stop going up very much/even go down in some cities when: interest rates rise to a high enough level to make the purchase of a new home a burden instead of a boon for first-time buyers; mild regulatory pressure begins to reduce the amount of funny-money lending; and, speculators sniff the beginning of the end; 2) Home equitisation should retreat shortly after; 3) Consumption/the US economy will then weaken when the house ATM starts running out of fresh new $25,000/$50,000/$100,000 home equity loan dollar bills; 4) The Fed (US Federal Reserve) will cut interest rates in order to start the game all over again. As to the timing of events, Gross says some clues are contained in recent papers published by the Federal Reserve. One paper follows a study of house prices in 18 countries since 1970. According to Gross’s interpretation, “it’s pretty clear that real housing prices have peaked on average four to six quarters after the central bank first raises interest rates and following what appears to be 200bps of short-term rate hikes”. The tightening then continues for another two quarters “for what looks like a total cyclical increase of 300bps or so”. The Federal Reserve has raised policy rates for five quarters for a total increase of 275bps – the average point where real housing prices have peaked for the past 35 years. Another paper, written by the soon-to-retire Federal Reserve chairman, Alan Greenspan, and a colleague shows that homeowners in the US borrowed $600 billion last year against the growing equity in their homes. Gross, says, that, assuming 50 per cent of this money is spent, home equitisation has added 0.5-1 per cent to US GDP growth. “Conditions 1) and 2) in my housing timetable then seem likely to unfold within perhaps the next three to six months,” Gross says. How weak the US economy gets depends on a range of other factors, too, such as oil prices, China’s continued growth and US interest rates. “If real housing prices decline in the US in 2006 and 2007, a recession is nearly inevitable,” Gross says. “If higher yields simply slow the pace of appreciation to a more rational single-digit number, then we could escape with a 1-2 per cent GDP economy.” In either case, the Federal Reserve is likely to lower rates by mid-year in 2006.