Ripping The Bandage
As a follow-up to yesterday's article, we take note of the home price data in today's reports. New Home Sales median prices didn't echo the spike in existing home sales, but as I said yesterday it is hard to draw much conclusion from this series, when there is so little volume that prices jump around significantly (see Chart, source Bloomberg).
However, on the other side the FHFA Home Price Index showed its biggest leap in at least a couple of decades. Again, one point does not a trend make, but the odds that existing home prices are actually rising - at least for the homes that are changing hands - just went up again.
But not all observers agree, to be sure. Readers of yesterday's comment fell into several natural categories. One large such category was the group that feels the large amount of shadow inventory that is held by banks in their REO books, as well as homeowners who are holding their homes off the market in hopes of higher prices, virtually guarantees lower prices.
I don't disagree with the general notion. The housing overhang is certainly not cleared, and it will take a while for it to do so. But the expectation that this inventory will depress prices further is based on a misunderstanding of the supply and demand relationship. It's really the fault of sloppy microeconomics texts, that tended to draw "supply and demand" charts with "Price" on the vertical axis and "Quantity" on the horizontal axis. This is accurate in the static equilibrium sense, when we are just taking a snapshot of the demand and supply curves to figure out the clearing price and quantity right now. But it glosses over an important detail and so misses conveying the richness of the relationship.
The "Price" axis need not be in dollars. There's no reason that it must be so - any exchangeable good will do. If I have a supply and demand curve for Yankees tickets, there is no reason that I can't have the 'price' axis in units of cups of beer. (In actual fact, that exchange regularly happens, as when one person says "come on buddy, I'll take you to the game and you buy the beer.") The curves will look similar, and there will be an intersection quantity and the clearing price will be in units of beer cups. Or ounces of gold. Or acres of farmland.
By putting the units in terms of dollars, we have to be very careful about interpreting shifts of the supply curve or the demand curve. Importantly, we must remember that when we shift those curves the assumption is that the shift happens instantly. When we use units of price that change in value constantly - as does the dollar - the intersection of quantity and price can move just because time passes. It is perhaps more useful to think of the "Price" axis as being in terms of "consumption baskets." How many consumption baskets will I exchange for that new car? Let's say the answer is ten. Next year, the answer will still be ten (assuming no change in my preferences). But if I answered in dollars, then the answer is different, and will tend to rise over time as the value of that dollar diminishes.
So yes, to clear excess housing inventory it's essential that home prices fall. But it isn't essential that they fall in nominal terms. If home prices rose 5% next year, but the price of everything else went up 25%, homes would be cheaper. This is actually better than seeing nominal prices fall by 20%, because it removes any incentive to default on a mortgage that is fixed in nominal terms.
Remember: supply and demand cross at the clearing real price and quantity, not the clearing nominal price and quantity, unless we are explicitly speaking only about an instantaneous equilibrium.
This misunderstanding is the same one that is at the heart of the commodities slide, which is beginning to feel to me more like momentum trading than investment flows. I keep hearing that commodities are declining on growth fears, but if that is so then why are coffee, hogs, and cotton leading the way down and not gasoline and copper? (And, by the way, how come when stocks decline it's a "buying opportunity" but when commodities go down, everybody thinks the world is coming to an end?) Commodities got pummeled again today, with the DJ-UBS down by -1.6%. Stocks got smacked early on and played with the 1300 level again, but managed a rally in the afternoon and actually ended with a gain of +0.2%. Bonds rallied again, and inflation swaps fell.
The near-term concern of course is Greece, with more and more stories coming out confirming that various European institutions have been developing "contingency plans" in the event that Greece leaves the Euro. Some observers think that Greece might even do it this weekend.
Once you've decided that the bandage needs to come off, the best way to take it off is to just rip it off in one motion. So, if Europe has finally come to that view, then the right thing to do is to just go ahead and do it at a time of your own choosing rather than letting events take the timing out of your hands. I seriously doubt that Greece will leave the EZ this weekend, with an election just a few weeks away, but it wouldn't completely shock me. I'm more shocked by the idea that all of these institutions are just now developing their contingency plans, when it has been clear for months, years even, that Greece had to leave the Euro. And I am a little shocked that markets apparently had completely discounted this possibility until recently, and are surprised.
Thursday's economic data consists of Durable Goods (Consensus: +0.2%/+0.8% ex-Transportation), which ought to show a partial rebound after an awful -4.2%/-1.1% showing last month. Initial Claims are expected to be unchanged at 370k. And liquidity will begin to suffer in the afternoon before a thin session on Friday.
 We assume here that they intersect above a zero price.