Leading Indicators: The Current Housing Market In 3 Charts
In every industry there are several reliable leading indicators. While anecdotal on their own, taken in sum the trends brought to light by these leading indicators have shown to be historically reliable in predicting what might happen next.
Today, I want to talk about three of the most notable and trustworthy leading indicators in real estate, and what they are telling us today:
The Months Supply of New Construction Homes
The 30-Year Mortgage Spread; and
Real M2 Growth
Figure 1. Months Supply of New Homes
Source: St. Louis Fed; U.S. Census; HUD
Months Supply of New Construction Homes
First is the month supply of new homes. Months supply is a measure that tells us how long it will take to clear the existing stock of inventory at the current pace of sales. A higher months supply figure means that there's a growing imbalance between inventory and sales. In this chart, months supply is inverted, which means as the green line moves lower, the months supply is rising. You can see that this indicator declined in advance of the 2007 home price decline as well as in advance of the 2013-2014 downturn in real home price growth.
Likewise, it led the rise in real home price growth in 2019. Interestingly, this metric also gives us some indications as to why real home prices did not decline in the 2000s recession: the months supply metric wasn’t showing any indication of a downturn or imbalance between inventory and new home sales.
In the current market period, we see that the months supply indicator started to show clear signs of a peak in real home prices at the end of 2020, leading the actual peak in real home prices by about a year, just as it has in the past and since that time has revealed a staggering imbalance in the months supply of new homes.
This is a very historically reliable indicator of a coming declines in real home prices.
Figure 2. 30-year Mortgage Spread
Source: EPB Marco Research
30-Year Mortgage Spread
While looking at the mortgage rates can be useful, these alone are not a reliable leading indicator. Instead, it’s necessary to look at the spread between mortgage rates and treasury rates. The reason for this is simple: the spread represents risk. Just as above, the 30-Yr Spread is also inverted in this chart, meaning the spread increases as the green line moves down.
As a general rule, mortgage rates can decline for one of two reasons: either because treasury rates are declining or the mortgage spreads are tightening (indicating reduced risk). Thus, in order to leverage this metric effectively, we must first determine which of these two factors is at play. Declining treasury rates can reflect worsening economic conditions which is why we have to separate whether the mortgage decline is coming from the treasury rate or from the spread.
A widening mortgage spread preceded the decline in 2007 and a tightening mortgage spread was a strong indicator of a recovery in 2010. However, there was a false signal into the 2000s recession where spreads were suggesting worse home price growth that never materialized. This is precisely why leading indicators must always be considered in context with other, reliable leading indicators.
Today mortgage spreads are widening sharply which is a negative sign for future home price growth.
Figure 3. Real M2 Growth
Source: St. Louis Fed
Real M2 Growth
Finally, it is worthwhile to look at the real M2 growth, which is a reflection of the real money supply. Despite traditionally being more volatile than the previous two metrics, real M2 growth can provide useful indications of recovery because excess liquidity will generally positively impact any asset price, including home prices.
Historically, major increases in real M2 growth lead to large increases in real home price growth. Case is point, the record increase in real M2 growth in 2020 and 2021 proceeded the record increase in real home prices that followed. Likewise, the large retractions in real M2 growth in the past have been strong leading indicators of real home price decline.
Today, excess liquidity is not on the side of home price appreciation. Rather, it is implying a sharp deceleration in real home prices.
In Conclusion
Looking at the collective signal presented by the three logical and proven leading indicators of real home price appreciation, the direction is clear:
Months supply of new homes is rising, which means new home builders will continue to reduce production and eventually, reduce prices of their existing inventory;
The mortgage spread is widening, which means lenders forecast greater risk in the housing market; and
The Fed is rapidly tightening liquidity, which translates into a negative impact on asset prices
These three leading indicators, which have proven to be very historically reliable indicators over time, provide a very clear signal as to where real home prices are headed. In fact, we’re seeing it already.