As 2019 winds to a close, and as I try to make sense of CME Case Shiller home price index contracts, I ask myself the question - "Which drives home prices - mortgage rates or the stock market"? This is both an open-ended review of my market making, with consideration for possible hedges, as well as a review of theory. I also tee it up to prompt debate about opportunities for 2020. Consider it a short weekend read to think about possible sector allocations.
A glib answer might be "yes", as in both the stock market and interest rates matter, but overall it may be a futile exercise as there might be so many additional factors that go into the decisions to buy and sell. (Endless academic papers have been written, and many home price forecasts are made using multiple inputs). Further, while my trading focus might be "how will prices move over the next week, or so, such that I can unwind a trade", the reality seems to be that home price moves are more glacial, leaving unduly long times for price reversals.
A recap of prices moves in the S&P CME Case Shiller 10-city home price index contract over the last two years may help illustrate the points.
Below I've graphed the HCIX20 (10-city Case Shiller home price index contract for Nov 2020) closes against: 1) the Fed St. Louis time series on 30-year mortgage rates, and 2) the S&P 500 index.
The first graph is consistent, during most of 2019, with the notion that lower interest rates (note left Y axis is inverted) tend to be correlated with higher home prices (or at least, as shown here, futures on home price indices). However that relationship did not exist for much of 2018. Contract prices rose from Jan 2018 to September, while mortgage rates were also rising. Only after Labor Day 2018, when home sales in California started to slow, did contract prices collapse. Note further, that they fell through Feb 2019, even as mortgage rates fell (and the Fed signaled lower borrowing costs). Net mortgage rates have fallen from near 5% in late 2018, while contract prices are about unchanged.
By contrast (see second graph) HCIX20 contracts rose in price during early 2018, while the S&P was grinding higher (from 2600-2800). The collapse in stock prices post Labor Day 2018 coincided with the decline in HCIX20 contracts (but then interest rates were also rising) so it appeared that movements in the stock market drove home price futures over this period. Again (as above) HCIX20 contract prices fell while the S&P index rebounded through early 2019, before snapping back. However since spring contract values have not moved, while the S&P index is up ~200 points.
Net, it appears that there are times when mortgage rates matter, there are times when the stock market matters, and there are times (to include the last few months) where neither seems to matter. This makes market making and hedging a challenge.
I pose the question then (and yes to drum up potential trading interest)^1, is it that the relationships between contract values and mortgage rates and stock prices are not particularly strong at the moment, is there another factor that is keeping contract values from participating in the rise of the stock market and low interest rates, OR, is this an opportunity to buy contracts vs shorting mortgage rates or stocks?!?
To the later I'd add that the mid-market of contract prices for longer-dated contracts are priced consistent with ~1-2% HPA (see table below), while many forecasters are calling for bigger gains. Recall also, that I think that contracts clear below expectations ^2 so if contracts are cheap to stocks, given the level of interest rates, longer-dated contracts (i.e. Nov 2022) may be cheaper still.
Note also, that while regional home price gains had a wide range for 2018 and 2019, contract prices for 2022 do not yet exhibit strong regional out-, or under-performance. Yes, the three largest components of the Case Shiller 10-city index (NYM, LAX and CHI) weigh down the overall index, while "stronger" regions such as BOS, DEN, LAV and WDC are priced for stronger gains, but given historical results, the dispersion across regions is mild.^3
Net, there doesn't appear to be a tight fit between stocks, interest rates and home price contracts at all times. Home price contracts can move for many reasons (to include thinness of the market) but there may be times when prices are out of whack with what people view as key drivers, that might present an opportunity.
Please feel free to contact me if you have any question from this blog, or any aspect of hedging home price indices.
Thanks, John
^1... and definitely not as investment advice (which I do not offer)
^2 - See past blogs for further discussion on this topic. See Oct 4 blog (Are CME Case Shiller quotes inconsistent with sentiment (#2): Core Logic forecast?) and Sept 19 (CME Futures: Expectations vs Clearing Levels, Opportunity or Bias?)
^3 - Feel free to contact me if you'd like to explore inter-city trades, an area I hope to detail in a future blog.