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August 7, 2022

4 Ways Housing Bubbles Affect Forex

Michael J. Donoghue
4 Ways Housing Bubbles Affect Forex

Throughout much of the developed world, housing prices have recently begun taking a tumble. Home valuations and rent costs had soared to unsettling high levels amid near-zero interest rates and other pandemic-era monetary stimulus; however, near-ubiquitous central bank rate hikes are beginning to bring many countries’ housing prices back down to earth. According to the Economist, in Sweden, home prices declined by almost 4% in June, while in New Zealand they have depreciated from highs for three consecutive months. Considering that real estate remains the biggest asset class in existence, and that housing markets arguably lie at the heart of global economic output, forex traders would be wise to consider these fundamentals when buying or selling pairs. Let’s explore 4 ways housing bubbles affect forex, as well as other markets.  

1) Measures Inflation Rates

For foreign exchange traders, gauging inflation within a currency’s host country is practically essential to fundamental analysis, since it often correlates with economic growth and helps analysts anticipate potential interest rate hikes. While there are many useful measurements of inflation, such as the Consumer Price Index (CPI) and core Personal Consumption Expenditures price index (PCE), measurements like the House Price Index (HPI) and home sales data are also relevant.

This is because higher housing prices and increased home sales are signs of a hot housing market, which indicates higher levels of consumer demand and thus potential inflation. After all, if house prices are increasing, this is typically because more people have money to spend on purchasing a home, whether through income or borrowing. This presupposes that they have general access to financing that they could use elsewhere, driving up prices in other industries too. Therefore, keeping up with the latest housing market data can be handy when it comes to assessing the severity of existing inflation.

2) Influences the Cost of Living

Besides offering data regarding pre-existing inflationary threats and spending patterns, housing market data can also give traders insight into how home prices transform the cost of living. For example, in the US in 2020, according to the Bureau of Labor Statistics, average housing expenditures were over $21,000 per ‘consumer unit’ and accounted for over one third of all consumer spending. This means that the cost of renting a home or taking out a mortgage has serious implications for the overall cost of living.

While rising home prices in general may not contribute to high levels of inflation, this past year’s sky-high prices are not ordinary circumstances: they are symptomatic of a bubble (when prices are far higher than they fundamentally ought to be), created artificially through low-interest loans. When central banks around the world incentivized easy borrowing through low rates and quantitative easing, they encouraged consumers to take out cheap, fixed rate mortgages and other debts while still spending more elsewhere, for the sake of economic stimulus. However, this short-term solution may have disturbing long-term consequences, as high inflation persists globally while rate hikes now abound in response.

3) Guarantees Revenue for Banks

Because commercial banks have multiple revenue streams that include owning mortgages and selling mortgage-backed securities, they have become instrumental to housing market activity. Due to acutely limited supply across many countries’ housing markets (for example, by some estimates, England is over 150,000 new homes behind in construction per year), many home buyers would not be able to afford the purchase without substantial loans from these banks.

However, ‘money-printing’-induced housing bubbles have further bolstered the banking industries via the housing market, and vice versa. When central banks encouraged bountiful lending, spending, and investing, increasing the number of homebuyers, this meant more clients for banks than would have otherwise existed, often including the central banks themselves.

By propping up the banking industries through these new borrowers and asset purchasing programs, this influx of capital also enabled banks to further profit from new investments, exacerbating inflation in a top-down manner due to the artificial, allocated capital. This is because, in many countries, commercial banks can also legally operate as investment banks, generating higher returns on investment by engaging in more risk. For example, this has been the case in the US since the overturning of Glass–Steagall in 1999.

4) Promotes Fragility, Not Stability

Between the recessions created by the 2008 financial crisis and today’s recessions caused by high inflation rates around the world, recent history offers a compelling case: housing bubbles promote economic fragility by accelerating expansion and contraction (i.e., boom and bust cycles). Unfortunately, for now, it appears that this lesson may have been learned too late, as the world’s central banks embark on a mission to crush consumer demand as a sort of necessary evil by venturing deeper into recessions in search of price stability. However, traders can learn to read housing bubble data accordingly, recognizing it for what it is: indications of severe overheating, followed by indications of impending contraction.

Key Takeaways

  • As housing prices decline across the globe following near-ubiquitous interest rate hikes, easing the real estate bubbles inflated by Covid-era monetary stimulus, traders should consider how housing bubbles can affect price action in the foreign exchange market.
  • Changes in house prices within a country can serve as a measurement of inflation, since appreciating prices attest to increased demand and spending, signs of a hot economy. These fundamental indicators are helpful for deciding whether to buy or sell a pair.
  • Regardless of whether consumers opt to rent or take out a mortgage, paying for a place to live makes up a large chunk of the cost of living in developed countries. Thus, housing bubbles built on low rates promote cheap, fixed rate mortgages, encouraging inflation.
  • When house values appreciate as more consumers purchase homes due to stimulus, commercial banks receive more clients, boosting their revenue and enabling them to allocate capital elsewhere. This exacerbates high inflation in a top-down manner, encouraging even more hiring and spending.
  • Between the 2008 financial crisis and today’s global inflation problems, recent history seems to suggest that housing bubbles promote economic fragility by accelerating boom and bust cycles. This might doom currency host countries to bad recessions or stagflation.

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