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June 16, 2017

The Fed’s “normalizing” agenda spells trouble for the housing market

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The Federal Reserve (the Fed) increased the target Federal Funds rate to 1%-1.25% on June 14, 2017. This is the second rate hike this year, following increases in December 2015 and 2016. Before December 2015, the Fed’s target Federal Funds rate, or short-term rate, was at zero.

By keeping the short-term rate low, the Fed indirectly keeps other interest rates low. For real estate professionals, the most important rates impacted by the Fed’s actions are mortgage interest rates.

When the short-term rate rises, adjustable rate mortgages (ARMs) see an immediate increase, as these rates are tied to index rates, such as the Prime rate. Fixed rate mortgages (FRMs) are still influenced by the Fed’s short-term rate, though they are only indirectly tied to it.

When the short-term rate increases, investor sentiment and demand shifts. For long-term rates, like the 10-year Treasury note, lower demand equals higher rates, and high demand keeps rates low. A higher 10-year Treasury note rate corresponds with higher FRM rates.

The Fed’s decision to increase the short-term rate usually results in a higher 10-year Treasury note. However, following the Fed’s most recent announcement to raise the short-term rate, the 10-year Treasury note barely budged from 2.14% before the increase to 2.16% according to MarketWatch.

Why? The Fed is raising rates, but it’s not due to higher inflation — in fact, the U.S. inflation rate has remained below their 2% target, and will likely continue at this sluggish pace for the next 12 months.

When inflation expectations are low, demand for long-term treasuries is high. This high level of demand keeps the 10-year Treasury note rate low. In turn, FRM rates will stay near their current level — for now.

The bigger impact on the housing market will emerge from the Fed’s other actions, and will play out in the next few months.

The Fed to sell off bonds

The Fed’s June 14 statement hinted at plans to reduce or “normalize” its balance sheet, consisting of a portfolio of mortgage-backed bonds and treasuries. The Fed increased its balance sheet as a tool to inject money into the economy during the financial crisis and recession when interest rates couldn’t (or wouldn’t) be lowered any further.

This is not great news for the housing market.

When the Fed begins pulling money out of the secondary mortgage market the supply of funds for mortgage originations dries up. Of course, the money supply won’t dry up completely, but it will make lending more risky, which is inherently more expensive.

Thus, FRM rates will edge higher as the Fed reduces its balance sheet. The Fed is noncommittal as of its June 2017 meeting, but indicates it will likely begin the shrinkage process sometime in 2017.

As such, know that today’s low mortgage rates will soon be history.

When FRM rates rise, home sales will slow as buyer purchasing power and demand wanes. Home prices will plateau and soon fall. This won’t be another crash the likes of 2007-2008, as the regulatory and economic environment are more solid in 2017. For reference, recall the Fed’s actions at the tail-end of the recoveries during the mid-1980s and mid-1990s. A slowdown is inevitable.

Factors that may complicate Fed plans are any events that set back economic expansion. For example, a collapse of the stock market or a significant slowdown in employment gains would halt the Fed’s balance sheet shrinkage program.

Keep an eye on economic news as it rolls in and, bar any financial shocks, watch for interest rates to move up later this year, and the contracting housing market to follow.

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