(See recent posts on Phoenix Case-Shiller Home Price Index.)

Housing futures contracts
could really change the game… in the future. Right now trading is so light that the prices don’t mean much.

The outlook for house prices is getting even gloomier as traders on the Chicago Mercantile Exchange bet on steep price declines and the number of homes for sale grows.

Traders on the CME expect home prices in 10 major cities to drop an average of about 10% from mid-2007 to November 2011, according to an analysis by Tradition Financial Services Inc., New York, of prices for housing futures traded on the exchange.

The contracts have been trading since May 2006 but last month were adapted so that traders could bet on prices as long as 60 months into the future. The trading is based on expected movements in the S&P/Case-Shiller house price indexes.

Trading is very light so far — about 20 contracts a day, a CME spokeswoman says. That means the contract values provide only a rough idea of the expectations of speculators and people hedging against house-price risks, says Anthony B. Sanders, a professor of finance at Arizona State University. But Dr. Sanders says the contracts are a useful signal, and he expects house prices generally to fall in the next couple of years.

The current contract prices show that traders expect prices in the Miami metro area in November 2011 to be down 28% from the mid-2007 level. (The indexes cover metro areas as defined by the U.S. Census Bureau.) The expected drops in other metro areas for the same period are 18% for Las Vegas, 12% for New York, 19% for San Diego, 26% for San Francisco and 13% for Washington, D.C.

One Big Problem

At last my Master’s Degree in Agricultural Economics comes in handy.

Since agricultural products are big on the futures market I learned (and forgot) a ton about futures contracts. It is my impression, however, that there is an interest rate component to futures contract prices.

If I think the price of corn is going to be the same in 1 year as it is today, I won’t buy a futures contract until the futures price is lower than my expectation to compensate me for having my money tied up in the futures contract for that year. So futures prices tend to be lower than traders actual expectations of spot prices at the time of the contract expiration.

When you get into these very long 5-year contracts, the effect could be huge.

So don’t take these futures contract too seriously until they have higher trading volume and that will likely take years.

Even then, you will need to compensate for interest rate expectations among the traders when guessing what the futures contract prices say about traders expectation for the spot price at the expiration date of the contact.