Keep the Housing Market on Your Radar

This week we learned that the construction of new housing continued to tumble in May. Housing starts fell to an annualized rate of 1.28 million for the month, which was down 6% from April and was the lowest level since June 2020. We also learned that building permits, which are a leading indicator of future housing starts, fell to an annualized rate of just 1.39 million – down nearly 4% from April and also the lowest level since June 2020. Economists had been anticipating much better numbers than these given the ongoing housing shortage. If the demand is there, why aren’t the builders building more?

In a nutshell, the problem is affordability. The cost of new home construction has gone up a lot in recent years due to rising interest rates, compounded increases in materials and labor costs, and the fact that builders in many parts of the country are finding that the supply of desirable land is constrained for one reason or another. But the larger issue may be that rapidly rising home prices and mortgage rates have sharply increased the cost of homeownership for prospective buyers. Many families simply can’t afford to buy an acceptable house with the cost of money approaching 7%. Affordability is also impacted by a relative lack of existing housing units for sale as many current homeowners are opting to stay put rather than move, clinging to their sub-4% mortgages and limiting the inventory of homes for sale to a relatively low 3.4 months (at current sales pace). The affordability issue is further compounded by rising costs for homeowner’s insurance and property taxes, both of which are directly related to the rapid increase in housing prices. 

The following chart shows that both homebuilder sentiment and consumer sentiment (with regard to the housing market) have tumbled over the past 2-3 years reflecting the aforementioned challenges.   

The final chart shows that despite the sharp decline in new and existing home sales, housing prices are rising again. Historically, these two metrics have had a positive correlation. The relative lack of supply of new and existing homes for sale is the reason for the divergence. 

The imbalance between the supply of and demand for housing is a critical issue right now because it is causing housing to continue appreciating, which along with surging stock prices is supporting consumer spending through the “wealth effect.” Though they won’t say so, I suspect that rising asset prices (stocks, housing) do factor into the Fed’s decision-making process. In other words, the Fed may be worried that cutting interest rates too soon might cause a continued surge in stock and housing prices, thereby leading to more robust consumer spending and therefore further inflationary pressures. But is it possible that the opposite could happen? Investors have been anticipating Fed rate cuts for so long now that they are likely already reflected in stock prices, at least to some extent. And lower mortgage rates might actually alleviate the problem of limited housing supply, bringing supply and demand into better balance and actually limiting further increases in housing prices. 

This doesn’t seem like rocket science to me. Fed policy is contributing to sizable financial-market dislocations and distortions. At some point the Fed will likely draw the conclusion that it’s actually doing more harm than good by keeping interest rates as restrictive (read: high) as they are. I also suspect that when that day comes, it will be too late to avoid an economic contraction and the correction in asset prices that generally comes along with it. It’s a good time to remain defensive.