June 3, 2009
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The Pace of Economic Contraction Is Slowing
The sharpest contraction in economic activity during the current recession occurred in the final quarter of last year when a massive financial shock threatened to wreck the U.S. and global economies. Real gross domestic product contracted at a 6.3% annual rate in that quarter as spending declined sharply for all sectors other than the federal government.

The “advance” estimate of GDP growth for the first quarter of this year showed a 6.1% annual rate of contraction, but this was revised to 5.7% in the “preliminary” report.

Available monthly data for the second quarter point toward a further slowdown in the pace of contraction, and we’re currently estimating a decline of 1.2%. We also continue to believe that GDP growth will turn positive in the second half of this year, partly because of a decreasing drag from the housing sector ― although the pace of growth most likely will be below-trend and not strong enough to prevent further deterioration of the labor market.

Recent signals from the labor market still are quite downbeat, but there are hints of a slowdown in the rate of deterioration. The cutback in payroll employment in April was not as severe as in earlier months, and the ADP National Employment Report released today points to a somewhat smaller decline in May.

Weekly data on claims for unemployment insurance still are quite recessionary, and continuing claims continue to climb to record highs. But the pattern of initial claims has been improving to some degree, at least on a four-week moving average basis, despite rising layoffs in the auto industry.

This pattern, if it continues, will signal the beginning of the end for payroll declines and we’re expecting stabilization of employment by early 2010.

Consumers Are Expecting Somewhat Better Economic Times

Major measures of consumer confidence and sentiment recently have been regaining some of the ground lost during earlier stages of this economic recession. The recent gains primarily reflect brighter expectations regarding economic conditions down the line rather than more upbeat assessments of current economic conditions.

The Conference Board's Consumer Confidence Index moved up in May following a solid increase in April but remained uncomfortably close to the record low struck earlier this year.

Consumer assessments of the present economic situation have hardly moved off the bottom, while the expectations component has moved back up to levels prevailing at the end of 2007 — the official starting point for this recession.

The Consumer Sentiment Index, produced by Reuters/University of Michigan, did not plummet into early 2009 to the degree shown by the Consumer Confidence Index, and smaller percentage increases were registered in both April and May of this year. The Consumer Expectations Index — a component of the sentiment index — is off the deck but still in a weak range.

The pickup in measures of consumer expectations apparently reflects the view that the end of the economic recession is in sight, partly because of the stimulus programs enacted by the government late last year and early this year. However, the absolute levels of this measure remain quite low, suggesting that consumers expect only a modest recovery in the latter part of this year.

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Housing Affordability Measures Continue to Improve

The affordability of home buying continued to improve through April, as declines in house prices and mortgage interest rates more than offset the effect of eroding median family income. The standard measures do not capture the effects of changes in mortgage lending standards or price expectations harbored by prospective home buyers, but the recent improvements are essential to a meaningful turnaround in home buying activity before long.

The National Association of Realtors® Housing Affordability Index has been hovering around record highs since early this year, and the April reading was up by nearly 30% on a year-over-year basis. All major regions showed gains of at least 20% during that period, paced by the West, which recorded a 41% year-over-year improvement.

The home mortgage market now is essentially a fixed-rate world dominated on the supply side by Fannie Mae, Freddie Mac and the FHA. The recent increases in long-term Treasury rates have put some upward pressure on these government-related home mortgage rates despite Fed purchases of Fannie Mae, Freddie Mac and Ginnie Mae securities, and the boost to affordability from falling mortgage rates presumably is behind us.

But house prices still are adjusting downward in many areas, and household income growth will pick up as the economic recovery comes together. Thus, housing affordability should remain quite favorable over the balance of this year and in 2010, providing vital support to the early stages of the projected housing market recovery.

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Consumers’ Views of Home Buying Conditions Continue to Strengthen

The Reuters/University of Michigan survey of consumer sentiment revealed that 80% of consumers had a favorable view of home buying conditions in May, up from 72% in April and the highest reading since early 2004.

Falling house prices have been the main driver of the recent upswing. They were cited by 74% of the consumers surveyed in May, a 60-year record proportion. Low interest rates also have been a key factor. They were cited by 40% of the respondents — the largest proportion to cite low interest rates since fall 2005.

On the other hand, very small proportions of consumers cited good economic times, concerns about rising interest rates or house prices down the line, or positive investment aspects of home buying as reasons for favorable home buying conditions.

The University of Michigan points out that about 90% of consumers in the May survey viewed home selling conditions as unfavorable.

Home owners always want to sell at peak prices, of course, but market realities dictate that sales must occur at going prices — just as subsequent purchases by home sellers will occur at reduced market prices.

Absent an organized effort to hold homes off the market until prices recover, sales volume will be picking up at prices close to or below current levels.

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House Price Depreciation May Be Easing Off

All measures of national average house prices have shown stunning declines from the unsustainable highs of 2006 to 2007. These declines have taken a heavy toll on household wealth, as well as on the quality of mortgage credit and the strength of financial institutions while restoring the affordability of home buying to a large degree.

Recent readings on home price behavior are quite a mixed bag, with some measures showing continuation of rapid rates of price depreciation while other measures are suggesting a significant slowdown in the rate of decline.

Stabilization of house prices is essential to a sustained economic recovery and, on balance, available evidence suggests that most of the house price correction now is behind us.

The S&P/Case-Shiller repeat-sales National Home Price Index was down by a record 19.1% in the first quarter of this year, compared with a year earlier, and the seasonally adjusted annual rate of decline for the quarter came to 24.9% — also the largest on record.

This measure now is down by 32% from the peak in the first quarter of 2006 and has returned to the level prevailing at the end of 2002 — prior to the unsustainable surge in home prices.

The repeat-sales purchase-only national House Price Index produced by the Federal Housing Finance Agency (formerly OFHEO) fell by 7.1% in the first quarter compared with a year earlier, and the seasonally adjusted annual rate of decline for the quarter came to only 2.2%.

This measure now is down by 10.4% from its peak in the second quarter of 2007 and has returned to the level prevailing in the first quarter of 2005.

The median price of existing single-family homes sold in April was down by 14.9% compared with a year earlier, paced by a 21.8% decline in the West. This measure, unlike the two repeat-sales measures discussed, is not available on a seasonally adjusted basis and changes in median prices are subject to compositional shifts, but it appears that the most recent rates of decline are not as severe as those recorded last year.

The major house price declines that now are under our belts have restored price/income and price/rent ratios to normal levels in many places and have combined with favorable mortgage rates to boost affordability considerably.

The improvements in home sales that we’re projecting should help stabilize home prices before long, assuming that government efforts to weaken the foreclosure wave prove to be successful.

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Home Sales Apparently Have Bottomed Out

The cyclical trough for home sales (seasonally adjusted) apparently was reached early this year, and a gradual recovery may very well be under way at this time. Sales of new homes (Commerce Department series) fell by 76% from the cyclical high in July 2005 to the apparent low in January of this year, but sales volume was up by 7% as of April.

It’s worth noting that the Commerce series does not recognize cancellations of sales contracts on the downswing or resales of homes handed back to builders via cancellations on the upswing. It’s highly likely that the series now seriously underestimates the actual number of homes being sold by builders, a proposition supported by NAHB’s proprietary survey of large builders that yields estimates of both gross and net sales.

Sales of existing homes (closings or “pending” sales) also peaked around the middle of 2005 and apparently hit bottom in January of this year before managing a modest recovery through April. The peak-to-trough decline was roughly half as big in percentage terms as the collapse in new-home sales, primarily because of the rising importance of foreclosure-related sales.

Distressed sales have represented about half of the sales volume reported by the National Association of Realtors in recent times. Such sales are bound to be a major force in the markets for single-family homes and condo/co-op units as we move ahead, bolstering existing-home sales and exerting downward pressure on prices in the broader market.

NAHB’s single-family Housing Market Index hit bottom with a record-low reading of 8 in January and moved up to 16 in the May survey. This measure is designed to capture builder sentiment regarding the demand side of the market, and the recent increases have at least mild positive implications for new- home sales in the near term.

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Backup in Long-Term Rates Will Not Prevent Housing Recovery

Long-term Treasury rates have moved up considerably from their recent lows in mid-May, even though the Fed is holding the federal funds rate near zero and committing to maintain that policy stance for an extended period. Long-term fixed-rate mortgage yields have been subject to some upward pressure in the process, moving above 5% for the first time since March.

In today’s testimony before the House Budget Committee, Fed Chairman Ben Bernanke said that the recent increases in long-term Treasury yields appear to reflect not only market concerns about very large federal budget deficits and extremely heavy Treasury issues but also greater optimism about the economic outlook and a reversal of flight-to-quality flows that drove down the Treasury yield curve to an unsustainable degree late last year and early this year.

Thus, in a sense, the backup in longer-term Treasury yields is a welcome development, suggesting that the panic mode in financial markets is moving behind us.

In this regard, the Fed apparently is not prepared to greatly increase the purchase of longer-term Treasury securities for its own balance sheet beyond the commitment ― $300 billion in 2009 ― made earlier.

However, the Fed is proceeding with efforts to reduce spreads between private borrowing costs and comparable-maturity Treasury securities, targeting sectors that are essential to economic recovery.

The spread between prime conventional conforming fixed-rate mortgages (FRMs) and 10-year Treasury yields exploded late last year and early this year, along with spreads in other private fixed-income markets (including the corporate bond markets).

But the FRM-Treasury spread has narrowed considerably since the Fed announced its intention to buy up to $1.45 trillion in agency debt and mortgage-backed securities in 2009, and the Fed so far has bought only $581 billion for its portfolio.

The recent backup in long-term rates has prompted some upward adjustment to our forecast of FRM rates over the balance of this year and in 2010, but we’re expecting further compression of the FRM-Treasury spread to limit the impact ― with the Fed’s help.

The mortgage rate picture still looks quite favorable by historical standards, and we’ve preserved the upswing in home sales needed to lay the ground work for an upswing in housing starts beginning in the third quarter of this year.

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