Why is US housing market so important for foreign exchange and commodity markets?

The US housing market is connected to the global economy in ways not anticipated a decade ago, so a focus on housing markets is a must for understanding the current global financial environment. This is a current special case because housing is usually not included in macro models of exchange rates. The impact of housing on exchange rates is usually indirect through the growth of the economy or through monetary policy, but the size of the current lending crisis makes it important to have an understanding of the ramifications on credit markets from a decline in housing. The importance on the global financial markets is threefold.

One, housing declines are linked with slowdowns in economic growth. It has usually been the case that recessions have been preceded by a slowdown in housing. While this does not happen in all cases, housing seems to be a leading indicator of an overall economic slowdown. If there is a weak housing market, there will be a corresponding slowdown in consumer spending. A slowdown in growth will negatively affect commodity prices and will have an impact on relative growth across countries which will lead to changes in the exchange rates.

Two, the securitization of sub-prime mortgages has distributed the credit problems of one country to other parts of the world. It has recently been announced that Chinese banks are holding large sums of CDO’s which are connected to the housing market. While these CDO’s are generally highly rated, their credit problems are dispersed to a wider range of buyers than would be the case if there was only domestic distribution. A global credit crunch can mean that there will be a tightening of lending standards all over the world as a reaction to this housing problem.

Three, the US is not the only place that may have housing woes. The rise in housing real estate in Europe has matched or exceeded the growth in the United States. The housing bubble of investors buying real assets as a response to the large sums of liquidity in the global economy means that a global tightening of credit could affect consumers in the entire developed world. This may be the contagion which could be a lot worse than the simple liquidity crisis of some structured products.