Convergence -Why the press should add futures to their monthly Case Shiller recaps

With the pending release of the Case Shiller indices on Tuesday, and given the collapse in markets, I thought that this would be a great time to reach out to the press to suggest that they expand their coverage to include commentary on the CME S&P Case Shiller home price index futures. (I encourage all users to forward this to the business/ real estate desks of local papers.) Recall that Tuesday's numbers will cover recorded home price closings over a 3-month window (November through January, on Tuesday's release), with a lag of two months - a period well before markets collapsed on fears of the COVID virus.^1 As such, reporting on the Tuesday's Case Shiller numbers may not contribute much to readers looking to determine the impact of the crises on forward home values.

The top graph illustrates the key concept of price convergence between derivative contracts and the reference index due to "cash settlement".^2 It is this convergence that may give merit to premise of the CME Case Shiller contracts having some predictive value. Below, I'm showing the Nov 2019 HCI (10-city index) contract (in blue) versus the HCI index (in black) over a four-year period through maturity in Nov 2019. Note that during this time, the futures traded in a range between ~220 and ~240 consistent with the notion that there were few surprises to forward expectations. Market prices had short term moves both up and down, reflecting, among other things, the level at which traders were willing to add/ reduce risk on exposure to changes in the eventual index value. There was a slight upward trend, that may have been due to either: a) slightly improving sentiment, or b) (as I suspect) the discount from futures versus expectations being amortized as contracts traded up toward expectations as maturity neared. As expiration approached the difference between the index and price on the futures contract narrowed, as convergence to expectations more likely dominated valuation.^3

Note that for the entire four years, the futures contracts traded above the then-current index, consistent with the notion that users of the contracts may have expected the index to rise (absent seasonal factors).

By contrast, the historical HCI index was almost continuously upward trending, with a few dips/slowdowns due to seasonal factors.^4 A review of historical Case Shiller indices during this time would confirm that prices had risen, but might not offer any insight on where they were headed.

The graphs below take the same approach using six regional Feb '21 (G21) contracts. As above, the historical Case Shiller index values are higher than a year ago (with most of any up/down cycles reflecting seasonality). By contrast, during the last month, the closes of six contracts have all recently dropped from closing above index levels to falling sharply below. ^5, ^6 While I might ascribe some of the decline in contract prices to increased traffic from users looking to hedge (thus widening out the discount contracts may clear versus expectations), I would highlight that these contracts have "only" (air quotes) one year to run, and as above, convergence will likely start to dominate clearing levels. As such, I would argue that the contracts are priced consistent with expectations of falling home prices. ^7

As a decline in prices (after ~8 years of increases) may be unusual, I expect there to be differences in opinions, and would encourage users (and the press) to better understand: how these contracts might fit into either forming an outlook, might be used to hedge (long or short), or might be used to express a view financially.

A key point to note is that these quotes are public, unlike surveys can be updated in real-time (like other markets), and unlike opinions, are backed by users putting money behind their bids and offers.

As noted in my March 17th blog, determining, and continually updating, clearing levels on the Feb '21 contracts may be key to creating liquidity in slightly longer contracts (e.g. Feb '23). Expectations may still have a role in Feb '23 (and Feb '25) contracts, but I'd expect assessing the discount (vs. expectations) traders assign to add/reduce risk will be a bigger factor. Follow for updates.

Please feel free to contact me if you have any questions on this blog, if you have any interest in discussing trading ideas for these (or any other Case Shiller) contracts, or any aspect of the use of home price index derivatives.

Thanks, John

^1 There are other home price index providers that produce a more timely update, but current release will all be calculated on activity before March 1.

^2 Note that this is the same feature that governs settlement values the S&P 500 index contract.

^3-Note that this may be the case today even in the midst of the current crises.  The May 2020 (K20) contract will settle on home price activity between January and March. As such, the inputs to the May release will have occurred by April 1st, and K20 trades shouldn't reflect (or hedge) what might happen, but rather expectations as to what has happened.

^4-Recall the NSA (non-seasonally adjusted) version of the Case Shiller index is the reference obligation for the CME contracts. As such, in a zero HPA environment, index values will rise in the spring and summer, while being lower in the winter. There is a modest amount of seasonality in the 10-city index as the colder areas (e.g. Chicago, Boston) have more pronounced seasonal moves, that are somewhat dampened by lower seasonal factors in warmer areas (e.g. Miami, Las Vegas, San Diego and Los Angeles).

^5-There is a much less historical information on the February contracts as this contract was only launched in Aug 2019. I've transitioned away from using November contracts e.g. Nov '22 (which will have longer histories) and as such, have not been updating prices.  Given a lack of bids and offers to update closing prices, I don't think that the Nov'22 quotes reflect next trade levels as well as the February cycle expirations.

^6 -I've shown the most volatile six of the ten regional contracts. Graphs on the other four (BOS, DEN, SDG and WDC) are available upon request.

^7- A reminder that these contracts are VERY thinly traded, that markets are often 1x1 (one lot bid vs one lot offered) and that many of the quotes are mine, reflecting both requests from users to provide liquidity, as well as my desire to provoke responses (i.e. better bids/lower offers, trades, trading ideas).