Will Higher Mortgage Rates Kill the Housing Market?

By Charlie Bilello

U.S. Mortgage Rates have risen for 9 consecutive weeks, hitting their highest levels since January 2014.

Source Data: Freddie Mac

That certainly seems like a sharp increase, but is 4.46% high?

Only when compared to recent history, which includes the all-time low in yields from November 2012 (3.31%). In a historical context, mortgage rates today are still quite low.

How low? Lower than 85% of monthly data points going back to 1971. The median 30-year Mortgage Rate over that time: 7.70%.

Source Data: Freddie Mac

After adjusting for inflation, real mortgage rates (at 2.5%) are also well below the historical median (4.2%).

Source Data: Freddie Mac, FRED

In the current decade we’ve seen the lowest mortgage rates in history.

Source Data: Freddie Mac, FRED

Why? After the housing collapse and financial crisis, the Federal Reserve made a recovery in home prices one of its primary objectives. They held the Fed Funds Rate at 0% for a record seven years (December 2008 to December 2015) and have since hiked rates at the slowest pace in history. Low short-term rates have pulled down longer-term Treasury rates, which in turn have pulled down mortgage rates.

Source Data: FRED

The Fed also purchased over $1.75 trillion of mortgage bonds in 3 separate rounds of quantitative easing, further suppressing mortgage rates. Until a few months ago, they had been reinvesting 100% of maturing bonds.

Source Data: FRED

For 2018, the Fed has laid out plans to gradually reduce its mortgage holdings: $8 billion a month in January, $12 billion a month by April, and a maximum of $20 billion a month by October. At a pace of $20 billion per month, it would take over 7 years for the Fed to unwind all of its mortgage holdings.

Nevertheless, this slow reduction in the Fed’s balance sheet combined with higher short-term rates (Fed plans to hike 3 more times in 2018) could put additional upward pressure on mortgage rates.

Which leads us to the central question many are asking…

Will Higher Mortgage Rates Kill the Housing Market?

The short answer: no. The long answer: it’s complicated.

While “all else equal,” a higher mortgage rate may be worse for the housing market than a lower one, all else is never equal.

Mortgage rates are only one of many factors influencing home prices. Other critical factors include: the supply of housing, the demand for housing, affordability, inflation, the availability of mortgages (how easy is credit), economic/wage growth, unemployment, demographics, etc.

There is little evidence that low mortgage rates by themselves lead to stronger home price gains. In fact, on a nominal basis, we’ve seen just the opposite. The highest nominal home price gains have come during periods with the highest mortgage rates (10.3%-18.4%) while the lowest nominal home price gains have come during periods with the lowest mortgage rates (3.3%-5.6%).

Source Data: S&P/Case-Shiller, FRED

Why might that be the case?

Home prices are correlated with inflation over long periods of time. This makes some sense intuitively as the price of a home should be related to the cost of building a home (material/labor inflation) and the ability to afford the home (wage inflation).

During periods of higher inflation, you’re more likely to see higher interest/mortgage rates, higher nominal GDP growth, and higher nominal home price growth. Conversely, during periods of lower inflation or deflation you’re more likely to see lower interest/mortgage rates, lower nominal GDP growth, and lower nominal home price growth.

But these are just longer-term averages and generalities, which in the short-run can mean very little. We saw that during the housing bubble years when home prices expanded rapidly (over 10% per year from 2002-2005) while overall inflation remain subdued (2-3%). The aftermath was not pretty and the decline in mortgage rates would prove to be no panacea. Housing prices nationally fell over 27% from the peak in 2006 to the trough in 2012. Since then, prices have recovered, rising 46% to hit new all-time highs. Over the past five years, home prices have once again widely outpaced inflation.

Will a more hawkish Fed and a continued rise in mortgage rates slow the pace of home price growth (6.3% over the past year)?

That certainly seems reasonable as it would result in lower affordability, but again, all else is never equal. If the rise in mortgage rates is accompanied by higher economic/wage growth and continued gains in employment, the housing market might do just fine. Far worse would be a scenario where mortgage rates turn back down as a result of economic weakness or another recession.

So perhaps what will ultimately “kill the housing market” is not a rise in mortgage rates but the inability for rates to keep rising. As I said earlier, it’s complicated.

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