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Good morning! Let me pose a question: are we approaching the end of the old economic cycle or the beginning of a new one? There seems to be a growing consensus that we are headed for, or already experiencing, a soft landing. But what happens after that? Will we see late cycle phenomena, such as rising defaults and growth stock outperformance? Or will we see early cycle phenomena, like improving earnings growth and value stock outperformance? I’m interested to hear your thoughts: [email protected].
House prices only go up, right? Despite thirty-year fixed mortgage rates reaching over 7% for the first time since 2001, house prices are on the rise again. This interactive graphic illustrates the surprising nature of this trend. The fastest mortgage rate increases in decades resulted in just seven months of declining house prices. Since February, prices have been climbing and last year’s decline has been completely erased.
The main reason behind this upward trend is the limited supply of houses. Years of insufficient construction have left the US with a chronic shortage of homes. Additionally, high mortgage rates have created a lock-in effect, discouraging homeowners from selling their properties with their current low fixed rates. Supply is currently at a record low, and even expensive mortgages are not enough to bring down house prices significantly. Take a look at the following chart to see the extent of this supply shortage, particularly in existing home inventory.
These dynamics are widely recognized. However, Larry Cofsky, Brandon Rowley, and Crawford Crooks of Bridgewater present an interesting viewpoint in a recent note. They argue that the supply-demand imbalance in the housing market could lead the Fed to maintain higher interest rates for a longer period. Here’s a summary of their argument:
– The increase in rates has significantly reduced housing demand. Mortgage borrowing as a share of GDP has shrunk by 3% in the first 15 months of this rate increase cycle, the largest decrease on record during the early stages of a hiking cycle.
– Despite the decrease in demand, house prices have not been significantly impacted due to the tight supply, as mentioned earlier.
– Distressed sales and housing construction are unlikely to boost supply in the near future. Homeowners are not forced to sell, given the resilient economy and healthy household balance sheets. Additionally, construction is not happening at a fast enough pace to alleviate the shortage. Bridgewater estimates that there is currently a shortage of 3-5 million housing units.
– The reduction in mortgage borrowing resulting from high rates has already occurred, leading to a small dip in house prices last year. Even if rates were to increase further, normal housing demand from growing families or divorces would provide support to prices and activity.
– Lowering rates could potentially lead to a resurgence of inflation through increased housing demand. Reopening the mortgage borrowing “pipe” would likely stimulate demand and raise prices. Given housing’s significant impact on growth and inflation, higher rates might need to be maintained to control housing market pressures.
This analysis of the housing market seems accurate, but there are a few factors to consider that could soften the impact of housing on interest rates:
First, the lock-in effect works both ways. While homeowners are currently holding onto their properties due to low rates, rate cuts would reduce the trade-off for homeowners. This might encourage more homeowners to sell, potentially increasing supply. The net effect of lower mortgage rates on demand and supply is uncertain and would depend on various factors.
Second, the relationship between the housing market and inflation is not straightforward. Inflation is measured through rents in the Consumer Price Index, and higher house prices eventually translate into higher rents. However, in the short term, there are positive signs in the rental market, such as record-high apartment construction, rising vacancies, and pre-pandemic rent growth.
While we acknowledge the points made by the Bridgewater authors, we remain slightly skeptical about the tight relationship between housing and interest rates for two reasons. Nonetheless, their macro point that the housing market’s transition from a downturn to a recovery could contribute to sustained price pressures and overall growth is strong. We believe that rate cuts are still possible, but the Fed is unlikely to rush into implementing them.
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