Using InterCity Spreads to take views on Fitch report -Part 1 (CME Futures)

Fitch recently updated their analysis of how fairly valued the 20 Case Shiller regions were on a longer term basis.  Fitch's results (shown in the table below^1) range from "Undervalued" to "Sustainable" to some percentage (e.g. 5-9%) over-valued.

At the one end, Cleveland and Detroit remain undervalued, while at the other, Las Vegas moved to even more over-valued at 20-24%.

While this may be of interest to home buyers ( as well as those in the RMBS securitization business, as Fitch home price outlooks may impact required credit subordination in new deals), I pose the question, if you agree with Fitch what might you do?

There are CME Case Shiller home price index futures that reference ten of the above indices. (BOS, CHI, DEN, LAV, LAX, NYM, SDG, SFR and WDC)^2. (I'll address what might be done with the other ten in Part 2.) As shown in the table below, the quoted levels for Nov 2020 expirations range from ~1.75% above spot levels for LAX and SFR to ~4.25% above spot for LAV and WDC. That is, the area that Fitch sees as most over-valued, has the strongest forward bid relative to its spot index, and one of the "Sustainable" areas -NYM -is quoted at one of the lowest premiums to spot (1.86%). ^3

While readers could take an outright view on LAV or NYM, another approach that does not involve an outright view on hoe prices, is InterCity (IC) spread trades (where one can simultaneously buy one regional contract while selling another at a fixed spread).^4 Such trades can be done at levels well inside buying one contract on the offered side versus selling another on the bid side. Translating the IC bids and offers (shown below) makes more clear the clearing levels for relative home price risk. For example, in the diagram below, the HCI (10-city)/ BOS IC contracts are priced at levels where BOS will out-perform the 10-city index by 1-2% by Nov 2020. ^5

As another way of interpreting the table of outright quotes above, the NYM (one of the "Sustainable" regions from Fitch) is priced to under-perform the 10-city index, while LAV (the most over-valued region) is priced to out-perform.

Traders can use these IC quotes (with 10-city index vs each regional contract) to express some of the above views, or can request quotes on any pairs of the ten regional contracts. I'd be open to facilitating any such IC trades and/or to work with you on outright views.

Feel free to contact me if you have any questions on this approach, this blog, or any aspect of hedging home price index risk.

Thanks, John

^1 Table reproduced from Dallas

^2 There are 11 contracts for each region with expirations that range (today) from Aug 2019 to Nov 2023. I'm going to use the Nov 2020 (X20) contracts as it is my benchmark for other expirations.

^3 This observation that a forward market (and therefore possibly expectations) are strongest in aarea that had strong recent price gains (as has happened in LAV), is not surprising to home price analysts. Momentum seems to be a large component of expectations. That said, this is where Fitch's work may have huge value in observing that a good thing may have been carried too far.

^4 Note that while one can do two trades at the same time, the notional values differ between the regions.

^5 A negative value is HCI under-performing