Thursday, July 22, 2010

The Correlation of Real Estate Markets and the Foreign-Exchange Market

Many new investors may be surprised to hear that an incredibly strong correlation exists between real estate markets and the foreign-exchange (FX) market. The primary driver of both real estate markets and the FX Market is risk. When investors are willing to take risk the real estate market appreciates a swarm of buyers enter the market. In the FX Market, when risk is present, investors will buy currencies that carry a high yield and sell currencies that have a low yield.

But as we all know very well from the Global Credit Crisis of 2008, when risk exits the market, and risk aversion, or an unwillingness to take risk, enters the market, then real estate values fall as there are more sellers than buyers, and currencies that have a high yield are sold and, generally, the U.S. Dollar is bought, since it is seen as the safest place to place capital during times of economic uncertainty.

Let’s take a look at a chart that depicts the movement of the U.S. Dollar before and during the Global Credit Crisis.

As you can see in this chart, the U.S. Dollar holds an inverse correlation with the Real Estate Markets. As the real estate market was booming throughout 2005-2007, due to low interest rates encouraging property speculators, the U.S. Dollar fell consistently. However, when Crisis hit in 2008 and the Sub-Prime Mortgage Crisis unfolded, the U.S. Dollar staged a remarkable bull rally as investors all over the world liquidated risky assets and put their capital in the low-yielding, but safe U.S. Dollar.

No as the economic recovery continues in the United States and around the world, it is becoming very apparent that the recovery is going to take longer than initially expected. Several months ago, in the beginning of 2010, the Federal Reserve actually began raising the discount rate in order to return to somewhat normal monetary policy. But as the recovery has continued, it is beginning to hit major roadblocks. Therefore, during the Federal Open Market Committee Notes that were released during the 2nd week of July, the Fed downgraded growth prospects in the United States, and instead of talking about when to enter a monetary tightening cycle, they actually began talking about when they may have to loosen policy again.

Much of this lagging growth in the U.S. recovery is to due to the housing sector, or the real estate market. Home values are still far off their HI’s. The housing sector did actually rebound quite nicely after the economy bottomed out in March of 2009, but the rebound was due in very large part to the economic stimulus the government had injected in the form of the $8,000 tax credit for first-time home buyers.

That tax credit was extended during the fall of 2009, but it was finally removed permanently in the Spring of 2010. Since the stimulus has been removed from the housing sector, economic figures are beginning to strongly disappoint the market. New housing starts are falling dramatically without the stimulus. This is causing the economic growth to lag in the U.S. and it is actually beginning to bring a bit of strength to the U.S. Dollar. This correlation is not perfect, and sometimes it is difficult to time the movement perfectly, but as a generality, when the housing market declines, on forex charts, the U.S. Dollar will be rising. If we continue to see a falling U.S. housing market, look for the U.S. Dollar to continue rising in the coming months.

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