Will the Sub-Prime Crisis Cause a Downdraft in the Dollar?

Is Housing Sending US Into a Recession?
Yesterday’s very ugly existing homes sales numbers have once again fueled speculation that weakness in the housing sector will spill over into the overall US economy, tipping it into a recession. While the news from the housing front is certainly bleak, calls for an economic contraction may be premature. For the time being housing appears to act as a slow bleed on the US economy rather than as a massive coronary that threatens to shut down the whole system. There are however several potential risks lurking in the background that could escalate the present situation into a serious financial crisis.

Housing Showing No Signs of a Bottom

Sales of existing homes fell in March by the largest amount in nearly two decades, dropping 8.4 percent off of February’s pace. It was the biggest one-month decline since a 12.6 percent plunge in January 1989, which was another contractionary period in housing. Sales in March recorded a seasonally adjusted annual rate of 6.12 million units - the slowest pace since June 2003. Furthermore, the steep decline in sales was accompanied by an eighth straight fall in median home prices, the longest such period of falling prices on record. Median price fell to $217,000, a drop of 0.3 percent from the price a year ago. Weakness in demand permeated every part of the country in March. Sales fell by 10.9 percent in the Midwest, down 9.1 percent in the West, 8.2 percent in the Northeast and 6.2 percent in the South.
Yesterday’s existing home sales report clearly demonstrates that housing shows no signs of hitting a bottom. Today’s New Home Sales data may provide some small evidence of a rebound, but even if the number improves to 890K from 848K the month prior, it is more than 30% below the pace set in July of 2005 when New Home construction reached 1367K level. In short, demand for houses has been curbed materially by the blow up in the sub-prime sector which has tightened lending standards, taking many potential buyers out of the market. Since pricing in housing tends to be extremely sticky to the downside (sellers strongly resist lowering prices on what is often the biggest component of their net worth), price drops tend to show the smallest response while sales volumes decline quickly and inventories usually skyrocket. Indeed, the latest data show inventories at 7.3 month supply up from 6.8 month reading in February. As a further risk, the latest batch of data is reported from sales which occurred in January and February?prior to the much publicized implosion of the sub-prime sector. Therefore chances of further deterioration in the sector are quite high.

No Serious Impact on Banks, No Easing from Fed
Yet despite the decidedly dour data, the contraction in housing has left most of the large players in the financial arena relatively unscathed. In the past week, Citibank, Wachovia and Bank of America all reported better than expected earnings?assuaging fears that the housing meltdown has affected their balance sheets. In fact HSBC, the only major bank to have suffered significantly from the fall-out in subprime, still retained a good portion of its equity and remains a financially secure institution. Since most of the mortgage business has been securitized, the brunt of the losses has been taken by bond holders rather than lenders. In other words, the default risk has been diversified across a broad spectrum of market players from hedge funds, to pension funds to foreign investors, leaving little systemic risk in its wake. Given this dynamic, the Fed therefore is unlikely to loosen monetary policy anytime soon. Despite the fact that many of the smaller mortgage originators have gone bankrupt while the threat of insolvency hangs over even the largest players such as Countrywide Financial, the Fed is only concerned with the health of the biggest money center banks. Until such time that we see housing related problems appear there, the monetary authorities are likely to remain pat.

On the other hand, the problems in the housing sector are severe enough to prevent the Fed from raising rate as well. It is this stationary aspect of the US monetary policy that has weighed on the dollar, as most its trading partners from Europe to UK to Japan are in the process of further tightening, compressing interest rate differentials in the EURUSD GBPUSD and USDJPY. Still the issue of additional tightening in the G-4 universe is far from certain. Neither the BoE nor the ECB have offered any guidance on their rate outlook beyond the anticipated 25bp hikes in May and June. Meanwhile, the BOJ is expected to be sidelined until the end of the Japanese Parliamentary election in July. Therefore, dollar bears counting on further deviation in short term rates between the US, Europe, UK and Japan may be disappointed. The one factor that could quickly alter the landscape in the US for the worse would be the sudden onset of a recession. To that end we need to examine the employment figures for any potential clues to the future.
Are There Still Jobs?
Up to now, the US employment situation has remained relatively strong. Despite the slowdown in housing, a massive loss of jobs in construction?prophesized by many dollar bears?has so far not materialized. Indeed, the latest unemployment reading of 4.4 percent has approached decade lows, while the 180K jobs created in March showed a marked improvement over the 113K jobs the month prior. Employment growth remains critical to US economic expansion because the majority of US consumers possess very little savings and already spend the vast majority of their incomes every month. Therefore, growth in consumer spending can only be driven my new workers at the margin, or possibly by further wage gains of the existing labor force. Both of those conditions require the creation of new jobs, which should provide more income for new workers as well as wage hikes for existing ones as labor pressures mount. Yet on the job front there are reasons for concern. As we recently wrote, “Weekly jobless claims are generally a minor event but next few week’s releases may take on a much stronger significance.” Note in the following chart how a rise in unemployment claims tends to presage contractions in the US economy. Remember that while employment statistics are based on surveys and are at best an estimate of the true state of the labor sector, unemployment claims are definitive and exact. Therefore, the disturbing rise in claims may bode badly for the US economy.

For the time being the slowdown in the housing sector has not had any serious impact on the US financial sector and, as such, is unlikely to force US monetary authorities to lower rates in the foreseeable future. However, the dampening effects of this key sector will also prevent the Fed from exercising their hawkish bias. While the problems in housing have not caused a sharp spike in unemployment, recent weekly jobless claims data provide cause for concern. If the situation does not stabilize and begins to exert a relentless downward force on jobs and consumer demand in the next quarter, the Fed may be forced to abandon its monetary discipline or risk tipping the economy into a recession which would certainly pose further problems for the dollar.