The transcripts from the Fed meetings from 2007 were released last week and they show that officials were keeping an eye on the CME Case Shiller (home price index) futures for clues to changes in sentiment about forward home prices. While I recognize that there was low volume, the message seems clear that the Fed was (and is still now?) paying attention to forward home prices.
The graph to the right shows the Case Shiller CUS (10-city index) in black, the trades (squares) and closes for the Nov 2007 contract in green, and the trades (squares) and closes for the Nov 2008 contract (from a report by Dolan & Hume, “Observations on the CME Home Price Futures Market: Were These Futures Able to Predict the Home Price Crash?”).
What the Fed (now says) that they were looking at in early 2007 was probably the Nov 2007 contract that was trading at a slight discount to the spot Case Shiller index. By the end of 2007, and more dramatically in early 2008, the Nov 2008 contract was trading at a sharp discount to the spot Case Shiller indices. (Recall that in the early years of Case Shiller futures trading that the longest contract was initially only one year forward. Longer contracts were later added that allow for a “fuller” forward curve).
Today, there is a five-year forward curve with prices that are consistent with 3-4% HPA for the CUS (10-city index). There are also ten regional curves that show some dispersion around that range. The forward curves have been upward sloping for at least the last year (see Dec ’11 curve) suggesting that the forward markets (and similar surveys e.g. Zillow) have been calling for higher prices since well before analysts starting noting the turn. Forward home price curves have continued to drift higher over the last year, and become steeper, consistent with improving expectations.
The message from the Fed transcripts seems to be -even if you don’t trade the CME Case Shiller home price contracts you should join the Fed and pay attention to what the prices might be suggesting.
Here’s some of the quotes from the 2007 transcripts:
- January 30-31
“Housing is an example of having more data, but not necessarily more information. Though some aspects of the residential housing data have been encouraging, neither futures on housing prices nor reports that I have received from people in the business suggest that the slowdown in that sector will end any time soon.”
- March 20-21:
“We have lowered the level of our forecast of starts and sales a further 3 percent to account for a more abrupt pullback in nonprime originations in the months ahead… in revising this aspect of our forecast, we have assumed that the increase in foreclosures associated with subprime difficulties will have only a small negative effect on overall house prices. We take some comfort from the fact that futures prices on the Case-Shiller house price indexes have edged only slightly lower in the past couple of weeks as this issue gained attention. We have also assumed that there is little spillover from subprime difficulties into the prime portion of the market.”
- Oct 31st
“Given the current state of the housing and mortgage markets, bigger declines going forward are a distinct possibility. Indeed, the Case-Shiller futures data for house prices point to larger declines in the months ahead.”
“Market expectations for the Case-Shiller index revised down, suggesting that the drop in house prices could be steeper than the moderate drop assumed in the staff forecast.”
“I think we have been seeing some significant declines in housing construction, but I see a potential for a reasonable likelihood of a much larger negative house-price effect than what the Greenbook has. As a shred of evidence for that, the incredibly illiquid Case-Shiller index that is traded on the Mercantile Exchange, if you look forward, for a number of markets they have a cumulative decline of 20 percent over a couple of years. Now, the number of players may be no more than the number of fingers that I have, but still it is a piece of data suggesting that it could be lower. The anecdotal reports are that real housing prices are much lower than the indexes are indicating. Certainly, in the new market, they are throwing in a lot of extras, add-ons, et cetera, and the inventory may actually be larger because the anecdotal reports are that a lot of people are taking their houses off the market, so they are not formally included in the enormous inventories that are out there but may well be potentially there for supply.”
- Dec 11th
“Indeed, the ten-city Case-Shiller home-price index has declined more than 5 percent over the past year through September, and futures contracts point to another sizable decline over the next twelve months.”
“As I mentioned last time, the Case-Shiller S&P index, although extremely thinly traded when you go out a year or two, is still suggesting potentially a 20 percent decline on average in the ten cities that they look at. So nothing has improved there, and given the tightness in the markets, given that we know that there will be more resets coming, given the continuing pressures, there’s probably going to be a lot more downside potential for housing prices, and that, of course, could again feed into lower consumer spending. So that’s the concern on the real side.”
These comments, and the resulting home price pattern suggest that even thinly traded markets (e.g Iowa Electronic Exchange) can convey useful information as long as a) there are no limits to trading, and b) the users of the product are aware of the market (and can then disagree with a higher bid/ lower offer/ trade). If a) and b) are true, it can be argued that the information imbedded in forward prices carries some weight. Yes, it would be better if there were 1-point bid/ask spreads and 100’s of lots trading every day, BUT absence of trading does not suggest that the numbers are “wrong”.
I have been following the futures off-and-on since inception and have been trying to work on “b” (awareness) as the market maker for the last 2+ years. Please feel free to contact me with any questions about the contents of this blog, or any other aspect of home price derivative trading at firstname.lastname@example.org.