As the economy shrugs off recession fears with unemployment hovering near record lows and the stock market continuing to heat up there is one major byproduct that could be impacted, mortgage rates. There was a ton of bad news priced into the market last year that did not come to fruition. How will this impact real estate in 2020? Why is this a wildcard for real estate?
The Federal Reserve does not “set” mortgage rates
First, it is important to note that the federal reserve does not directly control mortgage rates. The fed controls the “federal funds rate”. The federal funds rate is the rate at which banks and credit unions lend reserve balances to other banks and credit unions overnight. In a nutshell this is the rate banks get on the money they are holding in cash/reserves. Here is a more detailed explanation from Wikipedia .
So how are mortgage rates set? Unfortunately, mortgage rates are not “set”. There is no government or private party that can set rates per se. Mortgage rates are typically based on the 10-year treasury yield. So how do mortgage interest rates increase?
Before discussing interest rates increases, it is important to understand how bond yields work. The most important piece of this equation is the relationship between a bond price and its return. For treasuries, it is critical to note that a bond price and its yield move in inverse. What this means is that a higher bond price results in a lower yield and vice versa where a higher yield results in a lower bond price. For simplification purposes, I will not get into the full details of why bonds function the way that they do. Rest assured that it works this way and will always work this way.
With this key piece of information, we can now understand why mortgages do not move in direct correlation with the federal funds rate. This became apparent when the federal reserve raised rates in December. Within a few weeks, mortgage rates had dropped below when rates started. How can this happen?
In the example above there was a flight to quality assets with the financial global turmoil. When there is a flight to quality (aka people desire to put their funds in high quality liquid assets like treasuries for whatever reason) ultimately drives bond prices up and therefore yields down, in turn mortgages have remained low. The opposite is beginning to occur
Why will mortgage rates increase in 2020?
The market has not fully priced in the “good news” throughout the economy. The economy is still doing quite well. Last summer, many economists, including myself, were predicting an imminent recession. For various reasons the recession fears were greatly overdone with consumer confidence and spending staying high and the labor market also remaining robust. The housing market also stayed relatively healthy. None of this good news was priced into the bond market and in turn mortgage rates were lower than economic conditions warranted. In August when financial duress seemed to peak, rates dropped to around 3.5%, subsequently rising to almost 4% today. Look for this trend to continue with rates rising to 4.25 to 4.5%.
Rates are the wild card:
As rates rise buying power of purchasers erodes. Higher rates means higher payments and this is especially true in higher cost markets like Denver or coastal cities. For example, on a 750k home in Denver, assuming 20% down payment, the mortgage on a 500k loan would increase by 5k a year (417/month) from the lows of last summer. Many buyers are already stretching as wages have not kept up with housing appreciation leaving them unable to absorb the higher costs. The short-term increase in rates will likely put a damper on home sales the first half of the year.
Short term cycle
Fortunately, this is a short-term cycle as rates will ultimately stay low versus historical standards. With all this financial talk why am I convinced yields will stay low (prices will stay high on bonds)? First, the international uncertainty will keep demand for treasuries high (think China’s market gyrations or Europe’s negative interest rates which were noted in the federal reserves press release). This international uncertainty has driven a demand for one of the most stable/safe assets, treasuries. Based on supply and demand, as there is more demand, prices will increase. Second, the fed is very nervous to raise rates. With almost every other developed country lowering rates to stimulate their economy the fed would counteract these measures if they acted too quickly. The majority of trade throughout the world is conducted in dollars, as the fed raises rates, the dollar becomes stronger which will hurt many economies and also hurt anyone exporting from the US (stronger dollar means US goods are more expensive). Third, the fed states that they are data driven, due to the sharp decline in commodities, US inflation has been mediocre so it is unlikely the federal reserve will move to increase rates. Finally, there are structural changes occurring in the economy keeping inflation low from new artificial intelligence technology displacing workers to other efficient “sharing” technologies (uber, Airbnb, grubhub, etc…). This trend will accelerate in 2020 and into the future keeping inflation low and ultimately mortgage rates low.
Although there will likely be a short-term rise in rates that will impact real estate in the first half of the year, the longer-term economic trends will keep rates low. In any case, it is a scary moment with lots of moving parts from international tensions to structural changes in the economy. Past performance is not indicative of future results, as they say on Wall Street, and that may be even more true in 2020. Don’t throw out your history books, but you may want to open your mind about what happens next as it will be a bumpy ride.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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