Rate Hikes and the Fed’s Goals
Finally, a 1/4% increase in Federal Funds rate. The immediate response from the banks was 1/4% hike in the prime rate to 3.5%. This may have some effect on HELOCs. Adjustable mortgages facing reset may also see some changes. These minor adjustments should however have no direct impact on the real estate market.
As for the 30 year mortgage rate, so far the reaction has been nothing more than normal daily fluctuations. Even if mortgage rates eventually settle at a 1/4% higher level, that is only $30 a month for a $200,000 mortgage, or $60 to $70 a month extra in household income to qualify for the same mortgage. A quarter point should not make much of a difference but what about half a percent or more?
This mansion in Pacific Heights, San Francisco was sold for a record price of $31 m. in 2015 – it netted its owners a $4 m. profit in less than two years. Reportedly no improvements were made to the property. SF is one of the regions in which bubble conditions are not merely noticeable, but are better described as “raging”.
Photo credit: Zilov / MLS
Richmond Fed president Lacker said that four rate hikes in 2016 would be considered gradual. Assuming that each hike amounts to a quarter percent and long rates move up in unison, we may see mortgage rates in the 5% range. Is the real estate market strong enough to support that?
San Francisco Fed president Williams said that the Fed aims to keep the economy running hot in 2016 but will target a 3.25-3.5% federal funds rate for 2017. He also opined that if a shock were to hit the economy and send it back to recession, the Fed would not hesitate to cut rates and perhaps buy more bonds. Is that QE4? At the same time, he acknowledges:
“We are still in a situation where most of our tools are fully employed. It’s like an army that’s got all of your forces out there, you don’t have a lot of reserves,” said Williams. “It’s hard to feel like, well, I’m feeling any kind of sense of victory or something.”
Fed policy is data dependent, so Ms. Yellen has said repeatedly. Is the real estate market part of this “data”? Yellen has also repeatedly stated that real estate is recovering, if too slowly. I am not sure how she defines recovery. Is she hoping for double digit price appreciation and the crazy 2 million per year housing starts we have seen 10 years ago?
Once upon a time, there were private lenders, portfolio lenders, private label MBS, agency MBS and other miscellaneous sources for financing a real estate purchase. Mortgage rates were determined by market supply/demand and only somewhat influenced by the short term rates the Fed controls. That changed after the QE operations. Housing is financed almost entirely by the agencies – Freddie, Fannie, VA and FHA.
Total mortgage debt outstanding for 1-4 single family residences, including non-agency debt, is $9.95 trillion. The first QE program started in early 2009. It took six years and three QE programs for the Fed to accumulate $1.758 trillion in agency MBS. For the entire calendar year, mortgage rates have held steady, fluctuating within a quarter percent of 4%.
During 2015, the Fed has purchased $338.4 billion of agency MBS. These purchases are not additional purchases, they are replacing maturing bonds and pre-paid mortgages. If the Fed were to allow maturing or prepaid MBS to roll off the books without replacing them at the rate seen in 2015, it would take 5.2 years for the Fed’s balance sheet to unwind all QE-related MBS purchases.
Mortgage backed securities held by the Fed – since the end of “QE3”, the number has largely remained fixed, as the Fed continues to replace all maturing securities. If it didn’t do that, the US money supply would deflate – click to enlarge.
The Central Planning Dilemma
What real estate data will the Fed be looking at in the context of monetary policy decisions? Unfortunately for Ms. Yellen, her predecessors have dug a really deep hole for her. Starting with Greenspan, Fed policy has been to accommodate or to accommodate more (see chart below). The real estate market has survived not by low rates, but by the continual lowering of rates.
The Fed, resp. Ms. Yellen have never mentioned a target for mortgage rates, but in theory they can try to park themselves at a specific bid/ask so as to exercise full control over mortgage rates. However, if mortgage rates increase and the Fed starts purchasing more MBS to counter the trend, it may trigger yet more selling and therefore push mortgage rates even higher.
The Fed may also be looking at the Case Shiller national index. Remove the sub-prime mania (the four years ending 2006) and the correction that followed, and the index now is rising above historical trend and at a faster pace than in the last 30 years. Look at the steep rise in prices since 2012. The market is screaming bubble. Is that the green light to tighten monetary policy further?
On the other hand, Corelogic reported that as of Q3 of 2015, 4.1 million or 8.1% of all mortgaged homes still have negative equity. 8.9 million homes have less than 20% equity. Also per Corelogic, 10.2% of all sales in October were of distressed properties. That does not sound very healthy. Should the Fed consider additional accommodation?
As a side note to this, the Mortgage Debt Forgiveness Act has been extended through 2016. In other words, debt “forgiven” in a deficient sale will not be treated as income. Those who have been in that miserable predicament for so many years, should get off their fanny and complete a short sale now. This may be their last chance.
There are so many things that are fundamentally wrong with the real estate market that I will leave most of them to future rants. For now, I would like to point out that the market suffers from an acute supply and demand imbalance, both geographically and in terms of its mix. All the demand in Silicon Valley is not going to help Texas, which may start to reflect the stress of the oil industry.
In high demand areas like coastal California, construction of low cost entry level housing is economically infeasible. As an investor it is more important to understand that if the real estate market heads south, the Fed will do whatever it takes to save it, as if it actually knew how.
I will close the first post of the new year with three observations:
- The market cannot handle a 5% or higher mortgage rate. Refinancing still accounts for over 60% of mortgage applications. At 5% or above, the only refinancing business left would be the government’s HARP subsidies. As for purchases, all stressed out first time buyers with high debt to income ratios and low down payments will be wiped out. Without the entry level, the trade up level is gone as well.
- The Fed is in control of the real estate on/off button, but I am not sure if the Fed or Ms. Yellen appreciate the precarious position they are in. I agree with SF Fed president Williams that all Fed tools have already been fully employed and there is nothing left. Transparency invites front-running. If the MBS market moves up (rates up/bonds down) in anticipation of tapering or more rate hikes, the Fed may have no tools left to effectively counter the move.
- It is impossible to tell what policy makers will do, especially during an election year. Voters will vote for wild unrealistic promises – the wilder, the better. If real estate prices depreciate, resulting in rising defaults and foreclosures, there will be zero chance that any branch of government is going to advocate allowing the free market to correct previous excesses.
In conclusion, it appears the Fed cannot raise rates and the Fed cannot not raise rates either. There are equally strong arguments for and against both steps [ed. note: this in fact a typical example for the central planning dilemma – the planners simply cannot know what the “correct” interest rate is]. Personally, I look forward to the trading opportunities the Fed’s actions will likely bring in 2016.
Charts by: St. Louis Federal Reserve Research
Image captions by PT
It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
Most read in the last 20 days:
- A Striking Chart
The Economy and the Stock Market As long time readers know, we are always paying close attention to the manufacturing sector, which is far more important to the US economy than is generally believed. In terms of gross output it is the largest sector of the economy, and it should of course be obvious that saving, investment and production are the only ways to create wealth. What's left of the Brooklyn Domino Sugar Refinery. Photo credit: Paul Raphaelson Contrary...
- Trump and Putin Narrowly Escape Assassination Attempt
The Gloves are Coming Off First a little bit of recent history. Readers are probably aware that some questions about the occasionally malfunctioning Deep State android... no, wait, we'll start again. Questions have recently been raised about the health of presidential candidate Hillary Clinton by various “alt-right” tinfoil hat-wearing conspiracy theorists, such as this one. The monsters are normally hiding under Hillary's bed, but lately they have come out into the open...
- US Economy - Curious Pattern in ISM Readings
Head Fake Theory Confirmed? This is a brief update on our last overview of economic data. Although we briefly discussed employment as well, the overview was as usual mainly focused on manufacturing, which is the largest sector of the economy by gross output. Pepsi factory in Baltimore, 1956 Photo via pinterest.com Readers may recall that we have pointed out for some time that there was quite a large gap between the data reported in regional Fed manufacturing...
- Why the Fed Destroyed the Market Economy
What Have You Done for Me Lately? Swing voters are a fickle bunch. One election they vote Democrat. The next they vote Republican. For they have no particular ideology or political philosophy to base their judgment upon. The primacy of the wallet. They don’t give a rip about questions of small government or big government. Nor do they have any druthers about the welfare or warfare state. In effect, they really don’t care. What’s important to the...
- How is Real Wealth Created?
An Abrupt Drop Let’s turn back to our regular beat: the U.S. economy and its capital markets. We’ve been warning that the Fed would never make any substantial increase to interest rates. Not willingly, at least. Groping in the dark, Yellen-style Each time Fed chief Janet Yellen opens her mouth, out comes a hint that more rate hikes might be coming. But each time, it turns out that the economy is not as robust as she had believed... and that a rate hike isn’t...
- Janet Yellen’s Shame
Playing Politics In honest capitalism, you do what you can to get other people to voluntarily give you money. This usually involves providing goods or services they think are worth the price. You may get a little wild and crazy from time to time, but you are always called to order by your customers. In the market economy, consumers reign supreme. There is no such thing as a “lost” vote in the marketplace; every penny spent affects production. Mises noted: “Consumers...
- Get Ready for a New Crisis – in Corporate Debt
Imposter Dollar OUZILLY, France – We’re going back to basics here at the Diary. We’re getting everyone on the same page... learning together... connecting the dots... trying to figure out what is going on. The new three dollar bill issued by the Apprehensive States of America. We made a breakthrough when we identified the source of so many of today’s bizarre and grotesque trends. It’s the money – the new post-1971 dollar. This new dollar is green. You...
- Donald’s Electoral Struggle
Wicked and Terrible After touting her pro-labor union record, the Wicked Witch of Chappaqua rhetorically asked, “why am I not 50 points ahead?” Her chief rival bluntly responded: “because you’re terrible.”* No truer words have been uttered by any of the candidates about one of their opponents since the start of this extraordinary presidential campaign! Electoral map (note that the coloration may no longer be applicable...) That Hillary Clinton is...
- The Economy, the Stock Market and the Fed
John Hussman on Recent Developments We always look forward to John Hussman's weekly missive on the markets. Some people say that he is a “permabear”, but we don't think that is a fair characterization. He is rightly wary of the stock market's historically extremely high valuation and the loose monetary policy driving the surge in asset prices. The S&P 500 Index and the NYSE advance-decline line. Most market internals weakened steadily until early February 2016, but...
- Hanjin Marooning in San Pedro Bay
Global Trade Reversal Expansions and contractions in global trade have played out over long secular trends for thousands of years. The Silk Road, for example, was established by the Han Dynasty of China in 130 BC, and allowed for continuous trade between East and West for nearly 1,600 years. In addition to economic trade, the Silk Road was also a conduit for culture and knowledge among its network of civilizations. A map of the main ancient Silk Road - click to...
- Great Causes, a Sea of Debt and the 2017 Recession
Great Cause NORMANDY, FRANCE – We continue our work with the bomb squad. Myth disposal is dangerous work: People love their myths more than they love life itself. They may kill for money. But they die for their religions, their governments, their clans... and their ideas. Famous French hippie and author Voltaire. He wears the same sardonic grin in every painting, whether he's depicted at a young or an old age, doesn't matter. His real name was François-Marie Arouet; he...
- The Donald Versus Killary: War or Peace?
War: A Warning from the Past Although history does not exactly repeat itself, it does provide parallels and sometimes quite ominous ones. Such is the case with the current U.S. Presidential election and the one which occurred one hundred years earlier. The Donald probably has the better slogan... The dominating question which hung over the 1916 campaign was whether the country would remain neutral in regard to the horrific slaughter which was taking place on the...