How much and how fast?

Marie M. Schofield, CFA, Chief Economist and Senior Portfolio Manager | August 29, 2013

  • The recent rise in long-term interest rates could negatively impact the housing market, which has been a driver of economic recovery.
  • The effect of higher interest rates will typically show up first in the data for new home sales data, which have dropped sharply.
  • The combination of skyrocketing rates and more expensive and rising prices has likely impacted the marginal buyer’s affordability for a new home.

One of the most worrisome aspects of the recent rise in long-term interest rates, aside from its devastating impact to fixed-income investors, is its potential impact on the housing recovery. Economies and markets can adjust, as long as the rise is gradual and extended. However, the amount and speed of that rise can affect financial conditions with the effect of slowing activity. Indeed, a section of the July Federal Open Market Committee (FOMC) minutes stated, “…some participants felt that overall financial market conditions had tightened significantly and could be a significant factor holding back spending and economic growth.” I would have to say housing comes first to my mind since it has been a driver for the recovery.

Two monthly reports out this week on the housing market appear to give a vastly different color as to the state of the housing market in the aftermath of that sharp rise in rates.

  • Existing home sales jumped 6.5% in July (to an annualized 5.39 million pace) with increases in both single-family and multi-family homes. Home re-sales have risen 17.2% in the last 12 months, the best year-over-year increase in two years.
  • On the other hand new home sales fell 13.4% in July (annualized 394,000 pace), the sharpest decline since the homebuyer credit ended in 2010, with the year-over-year increase now only 6.8% the weakest in two years. Revisions were negative to prior months too. Sales fell in all regions—so it cannot be attributed to poor weather somewhere.

HomeSales

What gives? We need to keep in mind that existing home sales are a look in the rear-view mirror—these are closings in July that reflect purchase decisions made two to three months prior. So these tend to be a lagging indicator for housing, particularly if conditions have only recently changed. The noted spike in July home re-sales is likely a temporary short-term response by potential buyers who jumped in to avoid further rate increases. New home sales, on the other hand, are a reflection of more recent conditions because these are sales contracts that are counted when a purchase contract is signed (not closed). Here is where the effect of higher interest rates will show up first in the housing data. But it is not just the rise in interest rates that may have dented activity—the cause is more complex.

First, while homebuilder sentiment is the best in years, homebuilder capacity remains somewhat strained (credit tight, and labor, land and material costs are high and supplies are low). New home inventories have started to build, rising from a low of 3.9 months in January of this year to 5.2 months in July. But a higher percentage than normal remain “under construction.” Completed home inventories remain quite low, about 10 percentage points below average, so supplies are still relatively tight.

Second, relentless home price increases are beginning to impact demand, particularly from the marginal homebuyer that is more income-constrained. These are typically first-time homebuyers where there is a ceiling for the amount of payments they can afford under and which they can qualify for a mortgage. Also, keep in mind that the median new home price is at a 20% premium to the existing home price ($257,000 versus $214,000). The combination of skyrocketing rates and more expensive and rising prices has likely impacted that marginal buyer’s affordability for a new home. The monthly cost of principal and interest for a new home based on median price and current rates recently jumped above $1,000 (versus $860 late last year). While the monthly payment for a median priced existing home is up in that time as well, it is a more affordable $850. So marginal buyers (like first-time homebuyers) may be more attracted to existing homes where there is more supply and lower overall prices.

So don’t yet cheer the jump in re-sales—it could reverse in coming months. And the outsized softness in the new home sales report does raise fears about the strength and durability of housing in the face of tighter conditions, particularly since the response to higher rates would been seen here first. Housing demand is basically a function of jobs and income where mortgage rates don’t get in the way until they become too high too fast. And it appears we are seeing the first signs of this—at least for the marginal buyer.

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