Unlocking the Golden Handcuffs

On Wednesday, the National Association of Realtors reported that total existing home sales fell to a 14- year low in September. With the commencement of the Federal Reserve’s rate-cutting cycle on September 17th, many Americans are eager to know the impact it will have on the housing market.

As a brief refresher, the Federal Reserve sets monetary policy by adjusting the Federal Funds Target Rate, which has the most direct impact on the short end of the yield curve. But it also will influence the direction of long-term rates, including the rates on 30-year fixed-rate mortgages. Prior to the Fed’s rate hikes in 2022, many homeowners were lucky enough to lock in mortgage rates as low as 2-3%. But as the Fed raised rates by 5.25% over a 15-month span, mortgage rates spiked in tandem to as high as 8%. This rise in borrowing costs, combined with the median home price surging over 50% since 2019, caused home affordability to plummet to its lowest on record.

As I’ve written before, the wide dispersion between the average effective rate on all outstanding mortgages and the current rate for a new 30-year mortgage is causing housing turnover to fall to multi-decade lows as current homeowners are reluctant to sell their house and give up their most prized asset – an ultra-low mortgage rate. Only large Fed policy easing will meaningfully change this calculus. Odeta Kushi, chief economist at First American Financial, recently said that some 12 million renter households could afford a median-priced existing home if mortgage rates fall to 5.8%. However, with two-thirds of all mortgaged homes having a rate below 5%, depressed inventory levels could continue to suppress housing turnover and drive home prices even higher.

This lock-in effect is having an adverse impact beyond on the housing market. Home improvement spending is also heavily influenced by housing turnover as movers tend to spend more than non-movers. During the pandemic, we saw a sharp pull-forward in demand for housing projects due to work-from-home trends, government stimulus, and an increased share of wallet to goods (vs. services). After COVID restrictions were lifted and homeowners were pleased with their recently renovated homes, Americans began to shift their spending habits back to services, sending the home improvement industry into a state of relative stagnation. Additionally, multi-decade high inflation and interest rates further incentivized homeowners to defer expensive repairs and renovations until borrowing costs normalize.

But like the real estate market, this too could be about to change. With property values near all-time highs, equity in America’s homes has risen 81% since 2019 to $35 trillion. This sharp increase in equity could soon lead to a spike in home improvement spending. Other home improvement market tailwinds include millennials entering their prime household formation age, disposable personal income outpacing inflation for the past six quarters, and the average age of the US housing stock hitting 40 years old (which will create increased demand for non-discretionary home repairs). The missing piece of the puzzle remains housing turnover.

With existing home sales down over 40% in the past four years and spending on home renovations contracting for the first time since the aftermath of the Great Financial Crisis, there is clearly pent-up demand waiting to be unleashed once borrowing costs finally hit that lower sweet spot. We witnessed a sneak peak of this exuberance when mortgage applications jumped 14% and 11% in consecutive weeks leading up to the Fed’s first interest rate cut of 50 basis points. Since then, the 10-year treasury yield has risen 60 basis points, and mortgage rates have returned to 6.5% from the September low of 6.1%. Undeterred by this, consumers have increased their expectations for lower interest rates in the near term and with that, their intentions to move residences.

Despite the recent spike in interest rates, consumers still expect rates to trend downward in the months to come. But the pace at which the Federal Reserve decides to cut rates and the ultimate terminal rate will be dependent on inflation, the resilience of the labor market, and the strength of the US economy. Even when we do get the lower interest rates we’ve all been eagerly anticipating, there is likely to be a transmission mechanism impacting the timing of any potential tailwinds for the housing market and home improvement industry. Homeowners holding out for a bottom in borrowing costs may be waiting for a while. The days of 2% to 3% mortgage rates could be confined to the history books and consumers may have to settle for a new normal. Barring a recession, I do not see the case for the 10-year yield to fall below 4% in the near-term, likely putting a floor on mortgage rates of around 5.8%. Sooner or later, would-be borrowers will tire of waiting for lower rates and housing sales will resume. We just don’t know how long it will take.