Bubbleburg!

The bubble is coming! The bubble is coming! Yeah, right … and so are the aliens, at the minimum those belonging to the Empire of the Rising Sun.

In the general order of things, when short-term interest rates of U.S. Treasury bonds go beyond long-term rates, market sentiment indicates that the long-term outlook is poor, and that the yields offered by long-term fixed income will continue to fall. This generates an inverted-provide curve, typically an indicator of a pending economic recession. So far, however, there has been no inversion of any consequences in the provide terms of U.S. Treasury bonds as measured from the 91 days by the 30 years redemption periods. In addition, long-term rates are behaving very, very well slightly because of the tremendous need for long-term treasuries that has been coming from places like Japan.

Clearly, most real estate investors care about the future of interest rates, and so do most lenders. In the United States, the Treasury provide curve is the first mover of all domestic interest rates and an influential factor in setting global rates. As governments compete with corporations and lending institutions to attract investors in the open financial markets, any bond or debt security that contains greater risk than that of a similar Treasury bond must offer a higher provide. For example, the 30-year mortgage rate historically runs 1% to 2% above the provide on 30-year Treasury bonds. While this is true to a certain extent, it has not influenced the spread between short and long-term rates in the beginning months of 2006. As long-term rates on treasuries are stationary, the recent hikes of interest rates seem to have affected only the short-term bond rates.

The Treasury provide curve reflects the cost of U.S. Government’s debt and is, consequently, ultimately a supply-need occurrence, central to the Fed’s monetary policy. If the Fed wants to increase rates, it supplies more short-term securities in open market operations. The increase in the supply of short-term securities restricts the money in circulation since borrowers give money to the Fed. In turn, this decline in the money supply increases the short-term interest rate because there is less money in circulation (credit) obtainable for borrowers. Which is exactly what has happened in the first few months of 2006.

But two additional very important events have also occurred, concomitantly. First, Japanese investors have and are snapping up U.S. treasury long-term bonds at a speed almost double that of equivalent long-term Japanese treasury bonds. Secondly, Chinese investors are beginning to do the same thing. Much to the dismay of Beijing, who recently announced its intention to issue long-term treasury bonds worth some 100 billion Yuans to finance mainly infrastructure development, science, technology and education facilities, environmental improvement and ecological conservation projects and technological upgrading in enterprises, Chinese investors and savers prefer not to transform their dollars into Yuans. already New Delhi is getting into the bond game. India – which all and by itself sits on a pile of some US $150 billion – is purchasing US Treasury long-term bonds and reselling them to Indians for a mark-up.

Bottom line, consequently, is that the only ones who seem to be worried about the American debt are, well … the Americans. Everybody else seems to be willing to give the U.S. Treasury all the credit in the world, literally. Which is not only a political vote of confidence for Washington but also, in retrospective, makes a lot of sense if one thinks about it. Since, if you are a non-US national sitting on a pile of US Dollars, and are looking to invest into low-risk securities there is no better place to invest your money than into debt instruments guaranteed by, well … the United States Government. Which fact is sure to lighten up with joy a great many Confederate faces in the Bush Administration, who are beginning to see their financial and foreign policies vindicated, at last.

How does all this affect American real estate consumers?

For one thing, if investors of the Asian Tigers are willing to inject their ‘Godzilladollars’ back into the U.S. economy basing their decisions only on the financial strength and good reputation of the U.S. Treasury, and without a corresponding increase in U.S. bonds long-term interest rates, it method that long-term mortgage rates are not going to increase. consequently, since adjustable-rate mortgages (ARMs) have interest-rate schedules that are regularly updated based on short-term interest rates, but not on long-term, homebuyers are better off to finance their similarities with fixed-rate loans, which are bound to become more attractive than adjustable-rate loans.

additionally, foreign investors such as the Japanese historically have viewed North American real estate assets inexpensive, if not outright cheap, compared with their domestic real similarities. If you are used to pay U.S. $1,200 per square foot for an apartment in Tokyo, nothing that North American real estate markets can throw at you is going to scare you one bit. Chinese holders of foreign real character, however, have never left North America. They have merely scaled down their real character assets, but there has not been any great exodus towards China. Which fact, all an by itself, indicates how the Chinese themselves eye with uneasiness the prolonged economic expansion of the People’s Republic. And rightfully so, one might add, in light of the growing discontent, chagrin and resentment caused with each and every passing day by the gap existing between the wealthy Chinese of the coastal regions vis-à-vis the immensely more numerous poor sections of the population in the hinterland.

Thirdly, with a self-sustainable debt financed by foreigners, the Fed’s job of managing the equilibrium between inflation and economic growth by the handling of interest rates becomes already easier, to the extent that it makes all the more doubtful the occurrence of the cascade of mortgage defaults with a flood of foreclosures, which in turn would bring prices down – the typical real estate bubble that a great many ‘bubbleologists’ have expected, for now with no foundation whatsoever.

Now more than ever it seems that the impact of the present cooling-trend that we are witnessing in North American real estate markets can only be interpreted as the consolidation of markets wealth achieved consequently far, and that this trend is expected to settle real estate markets to new, more commensurate pricing levels before appreciation will surge upwards once again. Particularly in light of the fact that there are nevertheless plenty of consumers out there – especially domestic buyers – who are ready, willing and able to buy.

Luigi Frascati

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