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A Less Curvaceous Yield Curve

Posted by: Peter Coy on November 1, 2005

What could kill the housing boom? David Rosenberg, the chief North American economist for Merrill Lynch, argues that the trigger could be a flattening of the yield curve.

Here’s what he told me in an interview yesterday:

If I was alone on a desert island … and there’s a lot of people who wish I was … and I had only one tool for analyzing the economy, it would be the yield curve.

The yield curve is simply a graph with interest rates running up the vertical axis and maturities along the horizontal axis. Like this graph, which shows the yield curve from today and exactly one year ago:

yield curve_24593_image001.gif

In normal circumstances, like one year ago, the graph of yields is nicely curvaceous, starting low and going up in a northeasterly direction. Interest rates for short maturities are lower than the rates for long maturities.

Now, though, the yield curve is getting quite flat. That's because the Federal Reserve is jacking up short-term rates to squelch inflation. Long-term rates are moving up only a little, probably because bond buyers think inflation won't erode the value of their bonds much. Maybe they think the economy will be so soft that inflation won't be able to catch fire.

A flat yield curve may seem like good news for homebuyers (no big jump in mortgage rates!). But it's actually a warning sign of an economic slowdown. For the housing market, it drastically decreases the appetite of lenders to issue mortgage loans, for one thing, because there's not much spread between their borrowing costs (at the short end of the yield curve) and their lending income (at the long end).

Here's what Rosenberg told me:

Fed tightening cycles really accomplish one thing ... they uncover, expose and purge the excesses of the day. When the yield curve inverts, you’re getting paid to be in cash. That’s when risk appetite tends to subside.

Borrowers are celebrating the surprising fact that mortgage rates haven't gone up much in spite of the Fed's tightening. But don't get too excited. The Fed is determined to clamp down on inflation, and if that hurts the housing market, so be it.

Reader Comments


November 1, 2005 2:19 PM

I'm not sure that a flat yield curve will have much effect on the housing market.

Everything I've been reading states or leads me to conclude that "big money" has already taken their gains in the market. It seems to be small money investors (zero down, option mortgages) that are propelling the market at this point; it's certainly not fundamentals.

Small money people aren't looking at yeild curves. They are making purchasing decisions looking at unsustainable recent gains. If a yield curve chart or other rational, proven devices were used we wouldn't be in the housing mess we are in right now.


November 1, 2005 2:26 PM

Quite true. Considering the large number of ARMs and interest only lending that have utilized short term rates, there has already been a significant impact due to these changes.


November 5, 2005 10:35 AM

The point is, when the yield curve flattens, lenders are less likely to offer exotic mortgages (the vehicle that has driven housing affordability on a monthly expense basis).

Bottom line, as the yield flattens, less people can afford houses, buyers are forced out of the market, inventories rise, investors realize its a poor investment and leave, we fianlly are left with only those who have to sell and those who will actually live in a house, and finally house price is determined by annual salary (not the expectation of appreciation and easy money policy of the last few years). This means housing value will correct to the point where house price = monthly affordability based on monthly salary.

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BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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