We have been writing about the housing sector’s important role in the economy for several years now. The sector remains quite depressed relative not only to the years prior to the financial crisis, but also to long-term averages. “Residential Fixed Investment” (which includes construction of new single-family and multifamily structures, residential remodeling, production of manufactured homes and brokers’ fees) as a percentage of GDP was just 3.1% in 2013 compared to 6.5% in 2005 and an average of about 4.9% from 1946 through 2007. As the National Association of Home Builders points out, however, housing’s influence in the economy stretches far beyond the narrow definition of Residential Fixed Investment. If we include consumption spending on housing services, says the NAHB, housing’s contribution to GDP has averaged in the high teens (18%-19%) over the past several decades compared to about 15.5% in 2013. It stands to reason, then, that the fate of housing and the economic recovery at large are very much intertwined.
So where does the housing recovery stand? Anyone who’s been reading our Market Commentaries knows we believe that the housing recovery is heavily dependent on low mortgage rates. Unfortunately, mortgage rates have risen since the lows of about 3.3%-3.4% in late 2012/early 2013 to about 4.3%-4.4% today. The table below shows the effect of that increase in mortgage rates on housing sales. There was a rather abrupt and dramatic decrease in the number of home sales right about when mortgage rates spiked up in mid-2013. The higher mortgage rates, combined with sharp increases in housing prices in recent months, have led to a sharp decrease in housing affordability. The decrease in affordability has lowered housing demand and reduced sale transactions.
In this next chart, we show that the spike in mortgage rates has contributed to a flattening in the growth of housing prices. While year-over-year price increases are still very robust, we suspect the growth rate in housing prices will begin to fall to reflect lower levels of affordability. How far will the growth in home prices fall? Tell me how high mortgage rates are going and I can give you a much better answer!
This last chart below shows that housing affordability, which had reached multi-decade highs, has now come back down to earth. Two of the factors affecting affordability, mortgage rates and housing prices, have moved in the wrong direction recently. The third factor, the level of incomes, has been relatively stagnant for many years (if we exclude those at the very high-end of the earnings spectrum). The net effect has been a rather dramatic decrease in affordability, which, as noted above, has slowed sales activity.
Some of you may have been reading about proposed changes to the status quo for mortgage-finance giants Freddie Mac and Fannie Mae. Together with the Federal Housing Administration, these entities own or insure over 90% of the mortgages that have been written over the past several years. Without getting into the specifics of the Congressional proposals, suffice it to say that the changes (if enacted) will result in less government involvement in the mortgage market. Effectively, this means that private companies will have to take over some of the functions that have been performed by these government entities. And because government backing has kept mortgage rates low, the removal of government backing has the potential to increase mortgage rates. We suspect that these changes will be deferred for now, but everyone should be aware that this risk exists.
To summarize, a rebound in the housing market has contributed greatly to the economic recovery. Higher housing prices have stimulated new construction and given many consumers the confidence (through the “wealth effect”) to spend more. However, this rebound could be threatening by rising interest rates. As we have noted in previous Market Commentaries, the fact that mortgage rates “are still low compared to historical averages” means very little. Housing activity and investment were stimulated by very low mortgage rates. Housing demand and housing prices were effectively reset to reflect these low levels of mortgage rates. Why? Because almost nobody pays cash for their home, and therefore the cost of borrowing is an extremely important determinant of pricing.
The Fed continues its very delicate balancing act. Janet Yellen knows that sharp increases in interest rates have the potential to derail housing and the economic recovery at large. For this reason (and because we think the recovery is still too fragile to support higher interest rates), we think the Fed will stay firmly engaged. We wouldn’t expect any dramatic surge in interest rates any time soon.