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   ARTICLE   |   From Scotsman Guide Residential Edition   |   March 2018

Canary in the Coal Mine

When should mortgage originators expect the next recession?

r_2018-03_fedewa_spot.jpgAn old coal-mining safeguard used caged canary birds to detect carbon monoxide and other toxic gases before they hurt humans. If the canary died, miners needed to get out of the mine quickly.

As the first quarter of this new year moves toward a close, fresh tax cuts and unpredictable stock markets have many people in the mortgage industry wondering how long this economic expansion will last. If only there was a canary that could predict oncoming recessions, mortgage originators and other financial professionals could know when to get their clients into safer products or out of the market.

This past November, Janet Yellen, then-chair of the Federal Reserve, stated, “My colleagues and I may have misjudged the strength of the labor market.” She said a weaker labor market coupled with low inflation would strengthen the case for gradually increasing interest rates. Most experts believe incoming Federal Reserve Chair Jerome Powell will follow the same basic course.

The question is, in this environment of lower corporate taxes and a generally strong economy, what does this mean? Will the new corporate tax cut push back the next recession a year or two? When will the cycle end, and when should originators help their clients get out of the proverbial mine?

Residential construction builders, for example, work with a one- to two-year lead-time, so, perhaps they should begin pulling back from investing earlier rather than later. Top mortgage originators want to know when the next recession will arrive, and how it will affect them.

Power of feelings

Even though the economy seems to be moving well currently, over the past year or so some housing-industry professionals — noting the historically long and weak expansion — have been saying: “I think we are in the late innings of this one, so we better be careful.” When pressed, most of these professionals seem unable to explain why they are concerned, except that they have a “feeling.”

These troubling feelings about the economy often accumulate into expectation curves, which then end up becoming self-fulfilling prophesies. This is what happened a decade ago. There were many happy real estate developers and borrowers in 2006 who had a feeling it was getting late in the cycle so they made preparations for a correction.

Sadly, the Great Recession was far worse than almost everyone predicted, and prices fell dramatically further than many expected. The aftermath was painful for everyone, including the mortgage industry. Now, with more than 100 months of expansion behind us, shouldn’t we get a better dashboard on the economy?

Have we learned anything from the last recession? Maybe it is time to dispel these “feelings” with some good old economics.

Patterns in lending

When we change from economic expansion to contraction, a pattern builds in the lending industry. At first, many customers are looking for loans because they want to invest in expanding home values.

As a result, the Fed usually starts to increase the interest rates in an attempt to stop inflation caused by an overheating economy. Then, after rates increase enough, borrowers start to get concerned and lending slows down.

If lending slows down a small amount — but the economy continues to expand — all is well. If major players in the market start to believe a recession is coming, however, then borrowing practices might begin to slow down a great deal. If this triggers a strong recession, like we had last time, business slows down greatly, and regulators start to change the rules in an attempt to learn from the experience.

If the economy is actually OK right now, when should mortgage professionals get concerned? 

Therefore, mortgage originators want to make the best use of their time before a recession, and have strategies in place to allow for a good transition to a recession when it does occur to protect their business. If you know when the recession is actually coming, you can plan accordingly.

Current conditions

If you study recessions and other downturns in the economy over the past couple of generations, you begin to see there are indicators that can be monitored to keep people’s knee-jerk feelings in line. The main indicators of an upcoming recession are inflation and decreased consumer spending.

Currently, the U.S. economy has low inflation and flat consumer spending. Unemployment is on the low side, historically speaking, but there is no sign that the job market is either overheating or slowing down. The housing market is steady, even though prices are increasing in many markets and inventories are tight.

Because of these factors, and a slow recovery over the past 100 months, the Fed cannot raise rates too fast or quickly end quantitative easing and unwind its balance sheet, which includes mortgage-backed securities as well as bonds and other securities, for fear of ending what has been a long but slow cycle of expansion. 

So, if the economy is actually OK right now, when should mortgage professionals get concerned? Well, the exuberant bull market last year could be seen as a sign that we are late in the cycle, but it also may be an indicator that there has been an international flight to U.S. markets for stability, and a sign there is still a lot of liquidity in the market.

Indicators to monitor

Here are some leading economic indicators that have proven illuminating over past recessions.

  • New Residential Construction Report. Known as “housing starts” on Wall Street, this U.S. Census  Bureau report shows what is happening with the new-home market. A steep decline has preceded all recessions over the past 60 years. As of this past December, single-family housing starts were at 836,000, which is about half the number of starts at the 2004 peak before the Great Recession. Single-family housing starts have increased every year since 2011, however.
  • Purchasing Managers Index.Created by the Institute for Supply Management, the PMI shows the health of the manufacturing sector based on new orders, inventory levels, production, supplier deliveries and the employment environment. A PMI of 50 indicates a balanced sentiment, while over 50 indicates an expansion and under 50 a contraction in industry.
    As of this past December, the PMI was at 60, and had been higher than 50 for 103 months.
  • Michigan Consumer Sentiment Index. This index compiles phone interviews asking how consumers feel about the economy. This indicator has, without fail, predicted every recession for the past 60 years. During 2017, the index was near 2004 highs, but below 1999 levels.
  • Inverted yield curve.Normally, long-term notes have a higher yield than short-term notes. If people are no longer betting on the future being better than the present, however, those expectations can create an inverted yield curve, which can be one indicator of an upcoming recession.

Over the past year, the U.S. yield curve has been getting flatter — meaning the spread between short- and long-term notes is still positive but it has been shrinking. That likely is the result, in part, of the Fed pushing up short-term rates to better modulate growth, while long-term yields have not budged much because inflation has been subdued worldwide, despite strong growth. In theory, however, the Fed’s recent efforts to taper its $4.5 trillion asset portfolio should create some upward pressure on long-term rates.

So, keep an eye on these proven indicators, but for now get back to the business of financing homes and helping clients realize their dreams. We could continue in this unprecedented slow recovery for years. The next time you hear a client or colleague say: “Well, it’s late in the market,” you will know the truth, and maybe can capitalize on your new intelligence.


 


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