Too Much of a Good Thing

Judging by the most recent data on housing prices, rising interest rates have yet to meaningfully impact the housing market. But the writing may be on the wall. The chart below shows that the median transaction price for an existing (previously owned) single-family home has been rising at a fairly consistent clip of between 5% and 10% since 2014. Prior to that, the growth rates were even higher. That’s the good news. The bad news is that these rapid gains in housing prices, combined with rising mortgage rates, low savings rates and high levels of consumer debt, may make further price gains much more difficult. And given the housing sector’s importance to the economy at large, we think it makes sense to temper expectations for accelerating economic growth.

Source: National Association of Realtors.
The first thing to note is that housing prices have been rising at a much faster clip than incomes since early 2012. This is true whether you measure incomes using Personal Income (produced by the Bureau of Economic Analysis), median Household Income, or median Family Income (both produced by the Census Bureau). In the table below, you can see the gap in the growth rates of Personal Income and median home prices over the past six years. This consistent variance means that home buyers have been willing to pay higher and higher multiples of their income to acquire their home. In fact, we estimate that the ratio of median home price to median family income, at about 327% for 2017, was at its highest level since 2007 after bottoming out at about 270% in 2011. It is true that some of the increase in home prices is due to a relative lack of supply. There is currently just 3.2 months’ of housing stock on the market (at the current sales pace) compared to the average of about 6.0 since 2000. But that fact is neither here nor there.   Whatever the source of the price gains of the past, those price gains (all else equal) make future price increases less likely absent stronger growth in incomes.
Sources: National Association of Realtors and Bureau of Economic Analysis
Median home prices and median incomes are two of the three inputs used to derive the Housing Affordability Index. As we all know, the third input has been moving in the wrong direction as well. Data from Freddie Mac tells us that mortgage rates have risen to a 4-year high of about 4.46% – up from a low of about 3.31% in late 2012. As a result of the increase, mortgage refinancings, which had been a source of savings for homeowners for many years, have plummeted to a 10-year low. But the more profound impact of rising mortgage rates could ultimately be the dampening effect on the growth in housing prices.
Now, your real estate agent or mortgage broker will probably tell you something like, “mortgage rates are still very low compared to long-term historical averages.” True, but not very relevant. Because many prospective homebuyers make their offers based on the size of their monthly payment, the far more important factor in determining housing prices is the change in mortgage rates, not the level of ratesrelative to long-term averages! Using the recent rate of 4.46% compared to the 2012 low of 3.31%, the monthly payment on a $300,000 loan would be about $200 higher (or 15% higher) now as compared to at the lows. If we were to assume that mortgage rates go to 6.00%, then the difference in monthly payment would be nearly $500, or 37% above the payment at the 3.31% rate. If the vast majority of people buy homes using debt, then lending standards and mortgage rates will, in large part, determine the change in housing prices.
 Sources: Freddie Mac and Bloomberg.

Rising interest rates are not just a problem for the housing market. The combination of rising interest rates and rapid increases in Consumer Credit outstanding, some of which is variable rate, have led to a bottoming in the consumer Debt Service Ratio and Financial Obligations Ratio – two metrics tracked by the Federal Reserve to determine how financially strapped consumers are. In essence, these ratios tell us how much of the average consumer’s disposable income goes to interest costs and other fixed costs, like lease payments. While these ratios are still very low from an historical perspective, we stress again that it’s the change in the level that matters when trying to forecast the impact on economic growth. The latest data we have for these ratios is for the third quarter of 2017. We would expect a sizeable bounce upward in the fourth quarter of 2017 and the first quarter of 2018 given continued growth in debt and the rise in interest rates. And remember, these ratios are averages, which means there are lots of folks that are already in hot water financially. This is especially true given the continued worsening in economic inequality between the “haves” and the “have nots.”
Source: Federal Reserve
Lastly, any discussion of consumer finances would be incomplete without touching on savings rates. In addition to serving as rainy-day emergency funds, savings represent deferred demand for goods and services in an economy that is heavily dependent on consumer spending. Savings rates have been trending sharply lower in recent years, partially as a result of improved confidence, partially due to higher costs for non-discretionary items, and partially as a result of stagnant middle-class incomes. In the fourth quarter of 2017, savings as a percentage of disposable personal income came in at its lowest level since 2007 at 2.7%. This does not leave much room for further decreases before going into negative territory. Therefore, we are going to need improved growth in consumer incomes in order to sustain recent rates of consumer spending growth (and therefore economic growth). Although we could get a temporary boost in take-home pay from the tax cuts, a large chunk of the tax cuts will benefit corporations and wealthier individuals. It is altogether uncertain whether or not sizeable amounts of these benefits will make their way down to average Americans. We continue to believe that more money needs to get into more hands before we can expect a sustainable improvement in economic growth. Consumer spending represented 69% of GDP in 2017. We now have new risks in the form of potential trade wars, which could negatively affect exports, and tighter restrictions on immigration, which could lead to labor shortages. Longer-term, there are only two ways to grow an economy: increases in labor hours and increases in productivity. The former will require immigrants (given our low fertility rates and retiring baby-boomers), and the latter will require investments in areas like education, training and infrastructure to improve productivity. And there is some urgency given the promises we’ve made in Social Security and Medicare.
Source: Bureau of Economic Analysis
We have said for the better part of a decade that our economy remains too heavily in debt and too dependent on (artificially) low interest rates. The Fed has raised short-term interest rates five times (by 0.25% each) over the past couple of years. Economists expect another 3-4 hikes in 2018 and perhaps more in 2019. Meanwhile, Congress recently passed spending and tax bills that will likely lead to multiple years of $1 trillion deficits. I was reading an article on Bloomberg the other day (“Bond Market’s Most Feared Traders Threaten Treasuries Once Again”, by Liz McCormick) which contained a stunning forecast. “To keep pace with this rising (budget) shortfall, net Treasury issuance to the public will average $1.27 trillion per year over the next five years, according to strategists at BMO Capital Markets. That compares to an average of $658 billion over the past five years.” Think about that for a second. Is it possible that our Treasury can raise that kind of money without leading to sizeable increases in interest rates? Was fiscal stimulus (and the associated increase in budget deficits) a wise choice in the 9th year of an expansion and at an unemployment rate of 4.1%? What will happen to the economy if the fiscal stimulus (tax cuts and additional spending) triggers inflation and causes the Fed to hike rates at a quicker pace than expected? The problem, as we see it, is that monetary policy and fiscal policy are now working against one another, likely making it harder for the Fed to execute a “soft landing”. And all the while, the debt balances grow.