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A statistical analysis of the up and downs of housing identifies two key financial predictors of residential investment. One important predictor of housing investment is the difference between the interest rate on 10-year Treasury bonds and the annual appreciation on housing. This is a measure of the real cost of a mortgage.
The other predictor is the spread between the rate on 10-year Treasuries and the 3-month Treasuries. This is a measure of credit availability. Banks make intermediation profits by taking short term deposits and transforming them into long term loans. When the yield curve is steep, that is when the long term rates are much higher than the short term rates, banks make automatic intermediation profits on every loan, but when the yield curve is flat, there are no intermediation profits and the activities of bankers shift from intermediation to the identification of risk. Banks then take a closer look at borrowers’ balance sheets and credit histories, and may insist on more collateral and a lower loan-tovalue ratio. This makes it more difficult to "qualify" borrowers and squeezes many potential buyers out of the market.

These two housing market predictors are displayed in the figure below in a way such that up is good for housing and down is bad. Thus we have the slope of the yield curve (10-year rate minus 3-month rate) and the appreciation minus the 10-year rate. The figure has the recessions shaded and the expansions unshaded. This figure reveals that the yield curve has been steep early in every expansion, and has always flattened or even inverted late in the expansion, precipitating the decline in housing. The net rate of appreciation was highest in the late 1970s which is when real per capita investment in housing was also at its peak. Weakness in housing appreciation in the 1980s and early 1990s contributed to a muted housing sector. Both of these measures were way down in 1980 when housing took a big tumble.

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* Edward E. Leamer,
Director, UCLA Anderson Forecast.
Check the link for author's profile: http://www.anderson.ucla.edu/faculty/edward.leamer/pdf_files/cv.pdf