US Real Estate Slowdown Casts a Long ShadowLast week, U.S. housing starts, a key economic measure of new residential construction, dropped to their lowest level since 2020, with single-family housing starts hitting a 16-month low. Meanwhile, overall housing inventory has climbed to its highest point since 2020, and new housing inventory has reached levels not seen since 2008. Despite a moderating mortgage rate, high prices continue to deter buyers, failing to stimulate housing sales. Combined with the ongoing slowdown in commercial real estate, the sector may face prolonged challenges.
While the Real Estate Select Sector could see short-term gains from declining interest rates, a significant slowdown in the sector may dampen these benefits. A long position in Utilities Select Sector Index futures (XAU) to capitalize on lower rates, paired with a short position in Real Estate Select Sector Index futures (XLR) to hedge the real estate downturn, offers a balanced approach against XLR's short-term gains.
US HOUSING STARTS TUMBLE, INVENTORY SURGES
U.S. housing starts fell to 1.238 million as of July 29, a 6.8% decline from the previous week and well below analyst expectations of 1.340 million. Single-family housing starts dropped by 14.1% to 851,000, marking a sixteen-month low. Although Hurricane Beryl likely contributed to this sharp decline, the real estate sector faces a more significant, underlying challenge.
The U.S. housing market is grappling with a surge in inventory. According to Realtor.com, overall housing inventory stands at 884,000, the highest level since 2020. Similarly, data from the National Association of Realtors (NAR) shows inventories at 1.32 million, also the highest since 2020.
The situation is even more concerning for new housing inventory, which has reached its highest level since 2008. At July's sales pace, it would take 9.3 months to clear the backlog of new homes.
Notably, the slowdown in housing starts has intensified, even as mortgage rates have moderated from their peak in May. Despite a 10% decline in mortgage rates since early May, housing starts have fallen by 8%, indicating that easing rates are not driving a meaningful rebound in housing sales.
In addition to the struggles in the residential real estate market, the commercial real estate market continues to struggle with elevated vacancies and mark-downs. Last Month, Deutsche Bank stated that the commercial real estate market would be further pressured during H2 2024 as the recovery they had anticipated was not materializing.
INTEREST RATE CUT WILL PROVIDE SHORT-TERM BOOST
Despite the challenges facing the real estate sector, upcoming interest rate cuts are expected to provide a boost through further declines in mortgage rates. However, this near-term support may not be enough to offset a potentially prolonged downturn. Rising inventory levels are not being matched by significant price reductions, and with a weakening labor market, homebuyers' purchasing power is likely to remain constrained.
The real estate sector is not the only beneficiary of lower rates. As noted by Mint Finance in a previous analysis, the utilities sector also stands to gain from declining rates.
Therefore, hedging a short position in Real Estate Select Sector Index futures (XAR) with a long position in Utilities Select Sector Index futures (XAU) mitigates downside risk.
The XAU/XAR spread has outperformed an outright short in XAR as well as the SPX/XAR spread during rate cut driven rallies in the XAR this year and remained resilient during the recent rally in XAR.
HYPOTHETICAL TRADE SETUP
The U.S. real estate sector is burdened by a surplus of inventory, as home buying remains sluggish despite moderating mortgage rates. High prices, combined with financial strain in a weakening labor market, are likely to keep sales low for the foreseeable future. Additionally, ongoing challenges in commercial real estate add to the sector's difficulties.
Despite this negative outlook, the real estate sector may still see some benefit from upcoming interest rate cuts. Historically, the spread between Utilities Select Sector Index futures (XAU) and Real Estate Select Sector Index futures (XAR) has shown resilience during such periods, offering an improved reward/risk profile.
CME Select Sector Futures serve as a capital efficient instrument to implement spread trades between different sectors. A position consisting of short 3 x E-mini Real Estate Select Sector Futures (XARU2024) and long 2 x E-mini Utilities Select Sector Futures (XAUU2024) balances notional values on both legs. CME provides a 60% margin offset for this trade, reducing the margin requirements to USD 11,940 as of 19/Aug.
The hypothetical trade setup described below offers a reward/risk ratio of 1.4x
MARKET DATA
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