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From PIMCO bond manager Bill Gross' latest monthly essay:

...this cycle in particular has been dominated by the accelerating trend in housing prices – making consumers feel wealthier and able to borrow/spend more money than ordinarily is the case. And so it has been a particular focus of PIMCO (and the Fed as well) to concentrate on the fate of housing in order to forecast the future of the economy, inflation, and therefore the bond market. It’s not looking that good folks – housing that is.

PIMCO’s on-the-ground analysts, who for nearly a year now have roamed the country with random real estate agents in search of local housing trend information, report that prices in many areas are actually declining which has significant implications for the economy, inflation, and interest rate trends. A just-released report by the National Association of Realtors confirms that nationwide the year-over-year housing price gains have virtually disappeared and seem to be heading into the red.

One of our centerpieces in analyzing this cycle dominated by housing is a Federal Reserve Study finished in September of 2005 entitled House Prices and Monetary Policy: A Cross-Country Study1. The 65-page treatise covers 35 years and housing cycles in 18 different countries including the U.S. While too extensive to go into detail here (and too singular to rely on entirely) I will summarize the critical two paragraphs:

We find that real house prices are pro-cyclical and tend to reach a maximum near business cycle peaks, often after a prolonged period of buoyant growth in activity has raised output above its potential level and inflation pressures have begun to emerge. Subsequently, real house prices fall for about five years and their previous run-up is largely reversed. Real GDP growth slows during the first year or so after house prices peak as do growth rates of private consumption and investment.

House price booms are typically preceded by a period of easing monetary policy with FF rates bottoming out about three years before house prices peak. Rates then reverse quickly (after the peak) in response to falling GDP growth (my emphasis).

While there have been myriads of Fed studies, many of which have proved fallible, I find many of the statistical correlations and conclusions in this one highly significant and certainly eerie in terms of the current U.S. housing boom: FF bottoming out three years (July 2003) before a housing price peak (July 2006?); buoyant GDP growth and inflationary pressures beginning to emerge (1st half 2006); and of course the critical follow-on conclusion shown in Chart III, a quick reversal of rates shortly thereafter (1st half 2007?).

On average, short rates have fallen by over 400 basis points once a peak in housing prices has been established, a necessary function of central bank policies worldwide in order to rejuvenate asset prices – housing, equity, and bond markets among them.

Source: Bill Gross: House Prices Heading Further Down