Canary in the Coalmine

 Two recent events could very well serve as a notice of the coming end to the large housing bubble propping up the US economy.  With ample liquidity bestowed upon the US by foreign governments eager to buy US treasuries and thereby keep their own currencies weak (and exports strong), the US housing sector has been a pillar of the general economy.  Home price gains spurred by low interest rates have allowed for equity extraction, capital gains profits, and great stimulation to sectors such as construction and real estate finance that depend upon a healthy residential market.  Two indexes that track the housing sector and general real estate market are the Philadelphia Housing Sector Index and the Dow Jones Wilshire REIT Index.  The Philadelphia Housing Sector Index had increased 54% from June 30, 2004 to its peak in late July this year, and the Dow Jones Wilshire REIT Index had increased 38% from June 30, 2004 to its own peak in late July.  Such gains in fairly broad indexes are a good measure of the speculative environment in the real estate sector.

However, in late July and early August two events took place that might very well signal the end to the exaggerated gains in the real estate sector.  On July 21 China allowed for a revaluation of its currency, the yuan, and in the first week of August the US Treasury announced that it would re-issue the thirty year treasury bond, which had not been sold by the government for the past four years.  The yuan revaluation, though expected, is important in that it signals a shift in China’s vast foreign exchange reserves to a basket of currencies.  This will over time reduce the dominant role of the dollar in China’s reserve portfolio, and will also, if the strengthening becomes more pronounced, reduce the flow of funds from China to the United States, thereby increasing pressure on US interest rates.

A short time after the Chinese revaluation, in early August, the US treasury made its announcement about the thirty year bond.  For a government that once appeared frightened that it would pay off the national debt, the announcement came as a sad reminder of the current trajectory of government finances.  Faced with large government deficits, the treasury can only increase borrowings, and will need the thirty year bond to provide itself an additional avenue to capital.  Over time the increased demand for debt will provide upward pressure on interest rates as more US treasury securities are offered for sale.

A sustained increase in interest rates would have a negative effect on the housing market and general real estate market.  It was not a coincidence that the Philadelphia Housing Sector Index fell close to 9% in early August, and the Dow Jones Wilshire REIT Index fell 10%.  The reversal in fortune seen by these two indexes may very well presage troubles to come in the real estate sector, in particular the residential markets of those areas that have seen speculative price increases.