The current economic expansion is set to complete its tenth year this fall, surpassing the 120-month expansion of the 1990s for the longest in U.S. history, dating back to the mid-1800s. However, despite a low unemployment rate and robust job growth, several forward-looking indicators have started flashing warning signs causing the outlook from my peers in the economics profession to turn negative. In a survey earlier this year for the National Association for Business Economics (NABE), two in three economists surveyed expected that the next U.S. recession would begin by 2021 (though not me for reasons discussed below).
Despite the potential warning signs and negative sentiment among my peers, the economy looks pretty good. The unemployment rate as of March 2019 sits at 3.8 percent, a very low level by historical standards. However, the unemployment rate is a poor predictor of future economic activity. The average number of months between the cyclical low of the unemployment rate and the start of the next recession is seven months.
Warning Signs
Financial market indicators, which move faster than economic data, have pointed to a deterioration in growth prospects. The yield curve slope, or the spread between long-maturity bonds like the 10-year Treasury and shorter maturities such as the two-year Treasury, has flattened substantially in recent months. When this measure of the yield curve slope inverts, a recession almost always follows.
The slope, as measured by the difference between the 10-year and two-year Treasury for April 12, was at just 16 basis points. Not inverted, but close. If you stick this yield curve metric into a simple probabilistic model of recession over the next 12 months, the implied probability of a recession starting over the next year is about one in five. That’s up from an implied probability of about one in six a few months ago.
Why might the yield curve invert? One key factor driving the slope of the yield curve is the likelihood of future monetary policy actions. Since late last year when financial markets expected further rate hikes in 2019, expectations have shifted dramatically. Market-based measures of expectations are now pricing in a significant probability that the next Fed rate move could be a cut rather than a hike.
Housing Markets Typically Lead the Business Cycle
Housing has typically led the business cycle in the United States, and housing market indicators have also been flashing warning signs recently. Home sales, housing starts, and house price growth all declined last year. While single-family house prices increased nationally in 2018, some regional markets experienced declines in house prices with sharp declines in house price growth rates in many markets in the western United States. For most of the economic recovery, residential investment was adding to overall GDP growth, but in the last three quarters, residential investment subtracted from growth. Fading housing market activity is a typical precursor to U.S. recessions, so many bearish analysts pointed to 2018 housing market indicators.
The decline in housing market activity wasn’t too surprising when you consider what happened with mortgage interest rates in 2018. At Freddie Mac, we track mortgage market trends very closely. My team helps run the weekly Primary Mortgage Market Survey, which tracks the average rate on several popular mortgage products going back to 1971. By far, the most popular product is the 30-year, fixed-rate mortgage. After nearly hitting a five-percentage-point average rate last fall, rates have fallen to 4.12 percent in our survey for the week of April 11, 2019.
The run up in rates last year was a significant factor driving the housing market slowdown in 2018, and this was not unprecedented. My colleagues at Freddie Mac have studied periods of interest rate increases and found that, following a period of sustained mortgage rate increases, home sales fell about five percent and housing starts fell about 10 percent. That isn’t too far from what we experienced with existing home sales in the fourth quarter of 2018, which were down eight percent from the fourth quarter of 2017 and housing starts were down about six percent over the same period.
Thinking Beyond the Business Cycle
Mortgage rates declining in early 2019 is a reason for optimism about housing market activity, but there is more reason for optimism than just the short-term boost from lower rates. When we look at housing market activity, it helps to think beyond the business cycle. Statistical decomposition of housing market indicators reveals medium-term (8-32 years) and long-term (>32 years) trends are important drivers of housing market activity. These trends reflect demographics that, over the long run, will dominate housing market activity. To think about this, we need to consider the housing market lifecycles of both the young and the old.
The Millennial generation will drive housing market activity for years to come. They have been slow to start their housing lifecycle compared to earlier generations, partly because of sociological changes and partly because of economic factors. My colleagues and I examined the factors driving household formation and homeownership for young adults of the Millennial generation as compared to Gen Xers at the same age. We found that sociological factors, like delayed marriage and lower fertility rates, were significant drivers of delayed household formation and homeownership among Millennials. However, these factors were dwarfed by economic factors such as declining labor force participation and higher housing costs. Our research showed that higher real housing costs explains almost half of the eight-percentage-point decline in young adult homeownership rates for Millennials as compared to Gen Xers.
On the other end of the age spectrum, my colleagues at Freddie Mac looked at the housing choices of seniors. They found that seniors born after 1931 are staying in their homes longer, and aging in place, resulting in higher homeownership rates for this group relative to previous cohorts. In total, seniors are holding 1.6 million housing units off the market by aging in place.
The boost in demand coming from the aging of Millennials and extended lifespan of seniors is putting pressure on a housing market that is unable to build enough homes. The result is continued pressure on house prices. Despite the recent moderation in house price growth, house prices are still outpacing incomes.
Over the next few years, housing demand will provide a boost to housing market activity. However, a significant longer-term risk is that the imbalance between supply and demand will trigger another house price bubble. The experience of the last decade shows that the inevitable collapse of a house price bubble is far more painful than the ebb and flow of the typical business cycle.
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