First if you laughed at the title, congratulations you are both a pop-culture junkie and an econ-nerd – this is a very rare combination. The ECB is widely expected to ease monetary policy and eventually increase the monetary base, but will likely stop short of full blown QE. Given the German reluctance to green light printing money and the better than expected economic data in Europe (released last week) it will be difficult for Mario Draghi to announce a new program. The odds favor making the easy money announced in June (TLTRO) more attractive to European banks. Nonetheless, it is clear that the ground is being prepared for sovereign bond buying by the ECB combined with a renewed appetite for fiscal stimulus.
As the ECB prepares for QE the debate has shifted to how this new money will impact the European economy. Similar to the United States, QE in Europe should manifest itself as portfolio rebalancing – this is a really fancy term that means banks will be more likely to buy risky assets. This eventuality has not been lost on investors as Spanish bonds have been the investment of choice over the last 2 years.
The following chart is from a Bank of America report on the US Dollar and it illustrates the yield differential, or spread, between Spanish bonds and US & German bonds. The spread has compressed dramatically, to the point where Spanish Bonds and US Bonds yield exactly the same amount.
Here is BofA’s explanation:
However, good things don’t last forever. The momentum behind the outperformance of Eurozone peripheral debt and Eurozone high yield credit has been slowing since the start of Q3. Indeed, so far in August Spanish 10y spreads over Bunds and Treasuries have widened. If this remains the case for another week, this would be the first month since last November when Spanish-German 10y spread did not tighten. To put this into perspective further, since September 2012, there have been only two months in which Spanish-Treasury 10y spread did not tighten. We are aware of the danger of making too much out of August price action, but this is consistent with the possibility that the relative demand for Eurozone fixed income assets may be finally starting to shift.
Since much of QE appears to be priced into European assets, investors have been looking elsewhere for high yielding assets. However, the hunt for yield delivers few options. The one place investors are looking? US Treasuries.
Of course the argument can be made that on a stand-alone basis treasuries may appear expensive, but the investment world is a relative value world. And relative to Spanish Bonds and German Bunds, 10 year US Treasuries yielding 2.3% look like a bargain. Therefore it stands to reason that investors will continue to buy US treasuries and keep yields low.
Of course low yields are very good for home buyers and by extension builders. In fact anyone owning real estate should benefit from European QE. The risk, however, is that European QE complicates US monetary policy. If the US economy continues to improve the Fed will need to raise interest rates, but the Federal Reserve does not control the rates on 5, 10 and 30 year bonds. Therefore, it is possible that as the US economy improves it could attract global investors, keeping yields much lower than the Fed would like. Additionally, if inflation stays at the Fed’s 2% target and 10 year yields drop below 2% then this could be fuel for a real estate bubble.
The following chart depicts the YoY change in the Case-Shiller 20 City Home Price Index and the yield on the 10 year Treasury Inflation Protected securities (TIPS). When the TIPS yield drops below 0.0% its means that the inflation is higher than the interest rate on a 10 year treasury bond.
Notice that as the yield on TIPS dipped below 0.0% in January 2012 the Case-Shiller index bottomed. If global investors continue to flock toward US Treasuries the same dynamic could occur once again. The difference being that European QE is just beginning, not to mention the expected easing from the Bank of Japan.
In short, we could be looking at a period where international investors have a long term incentive to buy US Treasuries. In turn, even benign inflation in the US would set up a powerful environment for housing. The homebuilders are the clear way to play this emerging trend and the most straightforward instrument is the US Homebuilder ETF (ITB). If you believe that the high end of the real estate market will be beneficiary then Toll Brothers is the stock for you.