Mortgage News & Commentary - Watching The Fed

By
Steven Lord

Watching The Fed

October 4, 2006

The direction of long-term U.S. interest rates is an element within the broad array of factors that make up the outlook for the U.S. housing market, and some would say it is among the most important. There is a widespread belief that although the U.S. Fed sets interest rate policy by determining the discount, or Fed Funds, rate, the bond markets determine the interest rates themselves. Proof of this assertion can be easily seen in the long lag between mid-2004, when the Fed began hiking the discount rate, and early 2006 when the yield on 10-year U.S. Treasury bonds finally began to rise in earnest.

This kind of dynamic is crucial to anyone with an interest in the unfolding drama underway in the housing market. In many ways, the fate of the housing “bubble”, if that is the best term, was sealed the minute the benchmark bond began to rise along with the discount rate, since mortgage rates closely follow it. From there, it was only a matter of a few months before sales dropped, inventories began to pile up and we began reading dismal statistics coming from the U.S. new and existing housing industry. It was to be expected, and while it won’t be pleasant for developers working on spec and folks who are used to earning their living flipping properties, it won’t be the financial Armageddon many fear.

In fact, it might not be anything close. Everything seems in place for a soft landing – monetary policy is not restrictive, the corporate sector is in very strong financial shape, energy prices are falling and yields on the 10-year are dropping. Most of this comes in expectation of slowing (not slow) economic growth and continued gains in productivity. Meanwhile, price pressure in manufactured goods imported from Asia continues apace, reducing inflation fears. Hard landings in an economy have typically required significant decelerations in investment, employment and credit, none of which appear to be happening right now.

This is all setting up for a bull market in bonds that will drive 10-year yields, at 4.6% today, back towards 4%. In turn, this implies lower, not higher, mortgage rates. Indeed, while the market is pretty unanimous in expecting the Fed to stand pat at the October and November meetings, more traders now expect at CUT in December than a hike. The tide has turned.

This does not mean the housing sector’s woes are going to end overnight. Inventories of new homes have ballooned from 1.56% of households to 3%, sales are falling and the sellers market is becoming a thing of the past. It is entirely likely that prices may fall in markets that are affected by a weaker regional economy (Detroit comes to mind), where speculative activity was high (e.g., condominium markets) or where a large proportion of new real estate has been developed for second homes (South Florida). And there will certainly be some kind of consumer spending retrenchment – recent studies have indicated that every $1 decline in real housing wealth trims as much as $0.11 from consumer spending outlays, although a recent missive from the World Bank notes that should the recent 25% fall in crude oil stick, consumer savings in heating oil, gasoline, jet fuel, etc. this winter may more than make up for the housing headwind.

The housing “retrenchment” is normal and necessary. No market goes in a straight line, and excesses are always removed when period adjustments take place. Right now, a soft landing looks not only possible but probable, and interest rates in both the markets and the FOMC should be heading DOWN, not up, over the next six months. While this doesn’t mean the housing market will return to the insane pace of the last few years, it does infer the overall economy may tolerate housing’s rebalancing better than many pundits currently expect. And for people in the market for homes and mortgages, this is good news; when added to the pricing power home buyers are beginning to enjoy in earnest, continued low mortgage rates could create a truly win-win situation.

Other Articles by Steven Lord:
Call To Arms
Refi Boom Over?
Other People's Money