Volatility has returned, generated by the equity market selloff last week. The S&P 500 suffered one of its swiftest 10% corrections and the Dow dropped more than 800 points. Both index declines marked one of the worst sell-offs since February, raising questions whether the almost decade-long bull market is at risk of turning into a bear market. The steepness of the drop prompted investors back into the relative safety of U.S. Treasuries.
As most people are aware, U.S. equity markets have been on a historic climb in recent years. The Dow and S&P have each reached multiple record highs since 2016 – buoyed by a strong U.S. economy and solid corporate earnings. As such, the recent sell-off in equity markets seems to be largely attributed to investor fears about rising interest rates and increasing global protectionism (see our prior commentary here).
After years of near-zero short-term interest rates, the Federal Reserve is raising its benchmark interest rate (currently a target range of 2.00% – 2.25% and projected to increase to 2.25% – 2.50% at the December 2018 meeting). And as the federal funds rate and treasury yields have gone up, so have other important interest rates, e.g. mortgage and other consumer interest rates.
What will happen to the housing market now that rates are rising again?
Prior to the 2008 financial crisis, the housing market heated up primarily due to lax lending policies and over-eager home builders constructing speculative properties. Homeownership rates and prices hit all-time highs back then, before crashing down as many borrowers went into foreclosure. In the years following the 2008 financial crisis, rising home prices due to limited supply and low interest rates, along with relatively stagnant wage growth combined to create strong affordability headwinds for many Americans (see Graph below). Until recently, however, those historically low mortgage interest rates were also one of the few tailwinds helping the average homebuyer afford to buy a house.
According to a recent article by CoreLogic, a leading provider of financial and property data, while the U.S. median sale price has risen roughly 6% over the past year, the mortgage payment on that median-priced home ($230,411) has increased around 13%, largely because of a nearly 0.6-percentage-point rise in mortgage rates over that one-year period (see Graph below).
With rates increasing, what effect will this have on the housing market? Will there be less competition among prospective homebuyers for the same house? Will home prices start to fall? Will they become affordable for the average American?
Let’s start by looking back at the highest rates in recent history. In 1981, the average 30-year mortgage rate was 16.64%, assuming the borrower also put 20% down and had decent credit. Just four years earlier in 1977, the average borrower would have gotten 8.85%; easily the most dramatic interest rate swing in the past 50 years.
This historic increase in mortgage rates hit the residential housing market hard, dramatically reducing mortgage and housing activity. According to a Freddie Mac article,
- “New mortgage originations fell nearly 40%, from $162 billion in 1977 to $98 billion in 1981.
- Annual single-family home sales dropped 36%, from 4.5 million to 2.9 million.
- The biggest decline was in construction, with housing starts for single-family homes plummeting over 51%, from almost 1.5 million to 705,000 by 1981.”
Since the 1980s, mortgage rates have mostly trended downward (along with interest rates, generally). Obviously, they could dramatically increase again, but the Fed has indicated in past years a policy of gradual rate increases, which should have relatively benign effects on housing and mortgage markets.
Which brings us to what is presently going on in the housing market.
Generally, mortgage rates tend to rise when the economy is growing, the job market is healthy, and wages are rising. In this environment, people can typically afford more and are more willing to take out a larger mortgage. At the same time, factors like inventory and cost of construction can drive housing prices up, which can have the opposite effect, dampening housing affordability.
The graph above illustrates how home prices in Ehlers’ three primary metropolitan markets (Denver, Minneapolis, and Milwaukee) have moved. The red line indicates the Case-Schiller National Home Price Index. Each line measures changes in the prices of repeat sales of single-family houses – meaning, the index tracks changes in the value of residential real estate over time.
As you can see, prices in the Denver and Minneapolis Metropolitan Statistical Areas (MSAs) have increased far more than the national average. The Milwaukee MSA has more or less tracked in line. So, what is driving the rapid increase in home prices? Should we expect these trends to continue in the near future?
As reflected in the chart above, Denver MSA home prices have increased dramatically from 2012, largely because a dwindling inventory of for-sale listings and Colorado’s strong population growth. Colorado, and Denver in particular, continue to attract new workers from more expensive coastal markets, and builders are not building nearly enough to keep up, especially with regards to first time homebuyers.
There are some signs, however, the housing market is softening (see a recent Denver Post article here).
According to the Governor’s August 2018 Task Force Report on Housing (available here), the Minnesota and Minneapolis housing market can be summed up in roughly one sentence: A tight housing market leads to higher demand and increased home prices.
A healthy housing market is supposed to have a vacancy rate – the proportion of vacant homes listed for sale – of 5%. The report suggests vacancy is 2.2% in the Twin Cities area, which the authors say is behind a 9% increase in home prices from last year. The report also notes Minnesota homes are 26% more expensive on average than those in neighboring states. The report also goes on to say Minneapolis experienced a dramatic drop in the housing supply around 2010 and 2011, followed by a sharp uptick in home prices in 2012 (also demonstrated in the chart above). In addition, more than 554,000 Minnesota households struggle to afford quality housing, a 58% increase since 2000.
The Governor’s solution: build 300,000 more homes by 2030, but there isn’t much detail on how (or where) this would be accomplished, and recent data suggest current housing market trends will continue into 2019.
Milwaukee has a similar story to Denver’s and Minneapolis’s in that a tight housing market has led to increased home prices, but the issue seems to be concentrated in certain parts of the metropolitan area. Like many other cities, a boom in luxury housing has not translated into alleviating the affordable housing crisis. While Milwaukee’s overall vacancy rate is a relatively healthy 5%, it’s closer to 20% in the impoverished neighborhoods on the north side.
Most building starts in the counties of Milwaukee, Ozaukee, Washington, and Waukesha continue to be focused largely on higher-end houses. Those factors, along with plentiful jobs, a strong economy, and continued historically low mortgage interest rates, suggest a housing market that will continue its current trajectory, despite rising rates. It also suggests home prices will most likely continue to rise in certain neighborhoods, but not others.
To address this issue, in February this year, Milwaukee Mayor Tom Barrett announced his “Ten Thousand Homes in Ten Years” affordable housing initiative, which is an effort to widen the positive impacts from the city’s downtown building boom. The effects of this initiative remain to be seen.
The answer: Maybe, it depends…
With interest rates and inflation expected to continue rising, building costs and home prices are expected to rise as well. The most recent low in the 30-year fixed mortgage rate occurred in September 2016 – a monthly average of about 3.81%. Assuming rates continue to go up, Freddie Mac suggests (see here):
“Assuming the average scenario [the average of movements in housing and mortgage markets during episodes of rate increases since 1990], the 30-year fixed rate would rise above 5.25% before declining…Under this rate scenario, mortgage originations are expected to fall by 30%, accompanied by more modest declines in home sales of 5%, and a decline in housing construction starts of 11%.
Another possibility is that mortgage rates increase for a longer period and remain elevated for an extended period…Under this scenario, mortgage rates are expected to increase by 238 basis points, with a 49% drop in mortgage origination volume, a 14% decrease in home sales, and a 32% decline in housing starts.”
In short, when and by how much mortgage rates will move in the near future are still uncertain, but it seems the expected increase in rates could suppress growth in the mortgage and housing markets if (and this is a big if) the increase is large enough or lasts for long enough. Otherwise there does not seem to be a strong correlation between rising rates and the housing market. For now, though, getting a mortgage is still relatively cheap compared to historical standards.
Although there have been several news articles suggesting gains in the Case-Schiller U.S. National Home Price Index have slowed (see here for an example), what may have a greater near-term impact on the housing market is the new cap on deducting mortgage interest and state and local property taxes – not necessarily rising rates. Keep in mind though, home prices may fall, but it may not be enough to make them affordable for the average American.
Trends in Municipal Bond Yields
The upward trend in muni yields, which began in early September, took a breather over the past three weeks (see chart below). Yields shot up a few basis points after the FOMC’s meeting minutes, which essentially said the Fed is ready to move rates higher, but have tempered a bit since then, essentially keeping pace with treasury yields. All in all, municipal bond yields have not changed much in the past few weeks.
The 30-day visible supply this week is about $7 billion, down from the $10 billion shown for the past couple of weeks, which helps to push pricing on short-term maturities up (making them more expensive) relative to U.S. Treasuries. That said, supply continues to be lower than 2017, which should help to support municipal bond prices.
Investment Trends – Ehlers Investment Partners
In September, the Fed raised the benchmark federal funds rate by a quarter percentage point to a range between 2.00% and 2.25%. This represents the 6th rate increase since December of 2016.
In a speech to business leaders in Baton Rouge, LA on October 23, Atlanta Federal Reserve Bank President Raphael Bostic suggested the U.S. central bank should take its “policy foot off the gas.” He also indicated the Fed doesn’t yet need to think about pumping the brake and supports continued gradual interest rate hikes until the Fed gets to a neutral policy rate. (The central bank has estimated that the “long-run” neutral level of the fed funds rate is 3% but has not clearly said if this estimate is valid in the short run.) “While there is some uncertainty surrounding estimates of neutral…my assessment is that we are still a few rate hikes away,” he said. When the Fed gets to neutral, Bostic said he would “look to see if consumers and businesses continue to act in ways that did not suggest a buildup of excesses.”
Cleveland Federal Reserve Bank President Loretta Mester said October 24 that President Donald Trump’s very vocal criticism of the Fed’s decision to raise interest rates doesn’t affect the central bank’s policy decisions. In a speech in New York, Mester also said the recent drop in stocks had not impacted her upbeat outlook for the economy. She further expounded that prolonged market weakness may damage the economy and change her thinking and indicated she saw no sign of an impending recession.
If the Fed continues this path of rate increases to the point where the fed funds rate reaches the perceived “neutral level” of 3%, public sector investors could see returns for local government investment pools (LGIPs) reach levels not experienced in over a decade. At a sustained 3%, earnings in LGIPs would be $30,000 annually per $1 million invested, a tremendous increase compared to less than $2,000 earned annually just 3 years ago. But just as short-term rates have risen over 1% in the last 12 months, history has demonstrated rates can fall just as quickly. Although it is tempting to “ride rates up” in the near-term, a consistent investment approach using a laddered portfolio, blending shorter- and longer-term securities, will provide predicable investment revenue over time, while mitigating interest rate risk.
Ehlers Investment Partners, with a combined five decades of staff experience, assists all forms of local governments in the development and implementation of investment strategies. Contact an Ehlers Investment Partners advisor today for assistance in evaluating your current investments and developing a strategy for consistent and predicable revenue.
IMPORTANT INFORMATION: PLEASE READ
The information contained herein reflects, as of the date hereof, the view of Ehlers & Associates, Inc. (or its applicable affiliate providing this publication) (“Ehlers”) and sources believed by Ehlers to be reliable. No representation or warranty is made concerning the accuracy of any data compiled herein. In addition, there can be no guarantee that any projection, forecast or opinion in these materials will be realized. Past performance is neither indicative of, nor a guarantee of, future results. The views expressed herein may change at any time subsequent to the date of publication hereof. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as "advice" within the meaning of Section 15B of the Securities and Exchange Act of 1934, or otherwise relied upon by you in determining a course of action in connection with any current or prospective undertakings relative to any municipal financial product or issuance of municipal securities. Ehlers does not provide tax, legal or accounting advice. You should, in considering these materials, discuss your financial circumstances and needs with professionals in those areas before making any decisions. Any information contained herein may not be construed as any sales or marketing materials in respect of, or an offer or solicitation of municipal advisory service provided by Ehlers, or any affiliate or agent thereof. References to specific issuances of municipal securities or municipal financial products are presented solely in the context of industry analysis and are not to be considered recommendations by Ehlers.