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The entrepreneur must estimate present and future costs and future revenues and therefore estimate whether and how much profit he will earn.” Murray Rothbard from Economic Depressions:Their Cause and Cure

Yesterday we learned from the U.S. Commerce Department that the pace of construction of single family homes increased in August and building permits for new homes hit a five-year high. This data was trumpeted as evidence of “continued resilience in the housing market recovery.”

We are not convinced. New homes starts are still far below their historic norms because the total demand for homes is not robust as wage and job growth are non existent and in the words and recent actions of Federal Reserve Chairman Ben Bernanke, the economy is weak and would tank if interest rates were higher.

We wrote back in June that the supply/demand inventory shortage would reverse in part because home builders would increase output to meet the artificially stimulated demand. Yesterday’s housing starts report shows that prediction to have been correct.

Home builders are falling for the trap.

Low Interest Rates and Rising Home Prices Encourage Home Builders to Increase New Construction

Home builders are taking their cues, not from the health of the overall economy and the ability of their potential customers to buy homes, but rather from the cues sent by the Fed’s artificial manipulation of interest rates lower through Quantitative Easing (QE). This in conjunction with low for sale inventory has artificially stimulated demand and driven home prices higher and encouraged home builders to rush to meet demand.

Indeed, spec home building is on the rise across the country.

Taking business decision cues from the Fed may be sensible but its also dangerous because the Fed, while it has a great influence over the direction of interest rates, will not ultimately dictate the direction of interest rates, the market will – and that direction is higher.

There is a disconnect between rising home prices and the weak health of the economy. The continued weakness in the economy caused the Fed to acquiesce yesterday to the continuation of its $85 billion a month U.S. Treasuries and mortgage backed securities (MBS’s) buying program. More QE should mean lower rates (at least in the short term) because the Fed’s continued purchases of U.S.Treasuries and MBS’s artificially boosts demand for those securities and drives rates lower than the market, absent Fed intervention, would be willing to accept. Take the Fed away as a buyer of U.S. treasuries and MBS’s and rates rise.

We saw over the past few months that the mere talk by the Fed of tapering QE purchases caused interest rates to skyrocket and the Fed’s backtracking from tapering yesterday caused rates to plummet.

Liquidity Trap?

The Fed may find itself in the world’s most expensive liquidity trap in the coming months as interest rates may ultimately rise and economic growth remain stagnant no matter how many $billions of securities they may buy. That is the real danger for anyone investing, including home builders, based on the false signals that the Fed is sending by manipulating interest rates lower. Higher interest rates would be a disaster for the housing market and new home builders. Yet home builders are taking comfort in the still relatively low interest rates, the Fed’s ability to keep them low and incessant media reports that the economy is recovering.

The artificially Fed induced low interest rates are perhaps sending a classic false signal to home builders causing them to make “malinvestments” in Mises’ terminology or over investments in new construction during the current boom/recovery period.

Many home builders made this mistake in the early and mid 2000′s leading to this not so creative destruction of their own inventory:

2009 Southern California New Home Demolition

History has a way of repeating itself and those who don’t learn from the mistakes of the past are doomed to repeat them. This housing bubblet is happening just a few years after the prior housing boom went bust. Events that happened just a few years ago should hardly be called history, rather, recent memory.

Are the mistakes of recent memory being repeated? Will we see scenes like this again in our not too distant future?

2009 Southern California New Home Demolition

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  • http://www.rktp.ca Rick

    Louis..great analysis! It is true…the FED cannot increase interest rates as..another flood of bankrupt homebuyers will be left with “physical assets” valued lesser than mtg value. I presume that Fed overall policy is devaluing USD = owing less debt to Sovereign funds and destroying the middle class = more p/t retail jobs.

  • http://smaulgld.com Louis Cammarosano

    Thanks Rick
    As we have been saying all along, the Fed has a No Exit dilemma. The longer it waits to stop monetizing debt at the rate of over $1 trillion a year the worse it will be.

    • http://rktp.ca/services/market-intelligence/ Rick

      I agree!

      • Bubbabear

        The Fed has lost control of rates , bonds & consumer confidence “GAME OVER” !

        • http://rktp.ca/services/market-intelligence/ Rick

          Very true…yet Long Term NET TIC flows data earlier this week..showing international investors purchasing more U.S. Treasuries…and money did not leave U.S. Personally, only one month of positive results compared to last 3 mths or more of negative TIC flow data. Overall, numbers are “fudged”.

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