Inflation came in strong again. This is interesting. On a monthly basis, core CPI is growing almost as quickly with Shelter as it is minus Shelter. Will this persist? Could we be seeing the beginning of a trend back to 2% inflation?
I have lost confidence in the short Eurodollar/long homebuilder position for now. There was a brief glimmer of growth in mortgages and home prices after the slowdown associated with the taper of QE3. But, for now, that seems to have subsided.
Yet, CPI data suggests that we might see an uptick in inflation. I think real long term interest rates will remain very low until real estate values recover. I had expected to see inflation, home prices, and real rates all recover together. But, if the current trend in inflation persists while mortgages and home prices remain stagnant, maybe we will see higher nominal rates while real long term rates remain very low. This complicates a speculative interest rate position.
It also means that the Fed could begin raising rates before we see a substantial recovery in new home building. That could lead to an outcome where short term interest rates, more or less, follow the path of the current yield curve, with a very slow climb relative to recent recovery periods. Maybe the yield curve doesn't reflect a thick tailed distribution of expectations, after all. But, it would mean that if the housing shortage continues to push on shelter inflation and the Fed treats that as a demand issue, we could see stagnation or a new recession before we see any improvement in housing supply.
Here are a couple of graphs showing the regime shift that I think we have seen in housing and long term interest rates. Until 2007, there was a long-standing relationship between housing and long term real interest rates. (Bond yields tend to be more cyclical, and they carried unusual inflation premiums in the 1980s.) But, since then, we have been in disequilibrium. So, before 2007, rising home prices were associated with falling real interest rates. But, since 2007, falling home prices have been associated with falling real interest rates. Unless we see renewed growth in housing, I expect real long term rates to stagnate or fall.
These graphs have proxies for housing returns using (1) Case-Shiller and (2) BEA data, and proxies for long term real interest rates using combinations of mortgage rates, 10 year treasuries, U. of Michigan inflation expectations, and core CPI, for periods pre-dating TIPS bonds. It looks to me like equilibrium rates would correspond to 10 year TIPS rates about 2% higher than they currently are and real home prices about 25% higher than they currently are. In equilibrium, interest rates lower than that would need to correspond with sharply higher home prices.
I think one simple rule of thumb here might be to expect the yield curve to invert at Fed Funds rates similar to today's 10 year rate (plus maybe a 1/2% added inflation premium from today's levels), but that if we allow the mortgage market to recover, then long term rates would recover, real incomes would rise with less inflationary pressure, and the yield curve would not invert until the Fed Funds rate reached 4%-5%.