This economic recovery has been the slowest post-recession recovery since World War II. Moreover, the Fed has been extremely aggressive in its attempt to stimulate economic growth. And just when it seemed as though the Fed had used every available tool in its monetary policy toolbox, they introduced Operation Twist. Operation Twist equates to the Fed selling shorter term bonds and buying longer term issues. The intent was to increase prices on longer term bonds, hence, placing downward pressure on interest rates which would help keep mortgage rates low and stimulate refinancing activity. A boost in refinancing activity would increase cash flow which would boost demand as individuals spent some of this extra cash. If successful, the housing rebound would accelerate, helping the general economy. Until recently, the Fed's mission had been considered highly successful. However, due to a rapid and sharp rise in mortgage rates, a slowdown in housing may not be far behind. Yes, rates are still very low, but the problem rests with the degree and speed in which they have risen, a scenario not seen since the 1960's. In this post, we'll take a closer look at the housing market and the threat to it that higher rates could pose. Let's begin with a brief discussion on interest rates.
Interest Rates 101
Interest rates are the rate at which borrowers borrow and lenders lend. Obviously, lower rates tend to stimulate borrowing activity and boost demand. Interest rates are influenced by a number of factors, supply and demand notwithstanding. In essence, the Fed controls the short end of the interest-rate curve and other factors hold sway over longer-term rates. We'll focus on the 10 year U.S. treasury rate since this is considered to have the greatest influence on mortgage rates. In May of this year, the yield on the 10 year treasury was 1.70%. About the same time, a 30 year fixed rate mortgage was around 3.35%. Two short months later, the 10 year treasury was up to 2.65% and the 30 year mortgage had risen to 4.51%. This spike in rates caused a number of potential home buyers and those considering refinancing to get off the fence and take action. This surge in housing market activity manifested as a short-term spike in the housing statistics. However, sales of new single family homes, which had been on the rise, fell off sharply from June to July by more than 13%. We have also seen a meaningful decrease in refinance activity.
Home Prices
Home ownership is considered to be part of the American Dream. Modern day politicians have used home ownership much as President Hoover used the phrase, "A chicken in every pot" in the election of 1928. However, a house is quite a bit more costly than a chicken. And, as we've learned, whenever the federal government gets involved in the "free market," the results can be disastrous. In the chart below, notice how home prices (blue line) rose in relation to total population (green line). Around 2003, the gap began to widen as a greater percentage of Americans became homeowners. Of course, as is true in economics, higher demand begets higher prices. Notice how home prices began to rise faster than the population, peaking in early 2006, moving sideways until early 2007, then crashing mightily. Pay particular attention to the point on the graph where home prices were the farthest above the population (early 2006-2007), because this is what a bubble looks like.
However, there is another statistic which tells the bubble story more clearly. That statistic is the relationship between median home prices and median income. For decades prior to the housing bubble, the ratio between median home prices and median income hovered around 3:1. In other words, if the median home price was $90,000, median income was $30,000, a ratio of three to one. By early 2007, because home prices had risen much faster than incomes, this ratio expanded to over 5:1. This was the strongest signal at that time that a bubble was present.
The Housing Market & The Fed
During the past several months demand for housing has been strong. In fact, builders in some parts of the country cannot keep pace with housing demands. This excessively strong demand may well be the canary in the coal mine. In short, if strong demand continues, housing prices will continue to rise, increasing the possibility of "Housing Bubble Part Deux." However, if interest rates resume their upward trend, the combination of higher prices and higher mortgage rates, if severe enough, will most certainly slow the housing recovery which is unwelcomed news for the overall economy.
Therefore, as the Fed continues to purchase $85 billion in U.S. treasuries and mortgage backed securities each month, investors are quite perplexed as to the timing of the Feds tapering. In other words, how soon will the Fed begin to reduce their bond buying-money expansion program, the aforementioned Operation Twist? Here's the dilemma. If the economy remains sufficiently weak, the Fed will not reduce it anytime soon. Conversely, if the economy begins to strengthen, the Fed will likely begin to reduce its purchases. Both scenarios make investors nervous. And, all this affects the housing market and the economy needs a healthy housing sector to flourish. However, since the government stepped in to try and prevent a total collapse, since the bottom didn't fall out, there was less downside. Hence, a slow and steady housing recovery is not that surprising.
Summary
Will mortgage rates continue to rise? Will home prices continue upward? Will the U.S. economy ever return to robust economic growth? Will the Fed begin to reduce their bond buying this September? I believe the answers are: Very possible; Yes; Yes, but it will take much longer than expected; and I highly doubt it. At least that's been the story thus far.
