Is the Housing Recovery in Danger?

When cattle are nervous, the slightest rattle can trigger a stampede. And that applies to nervous investors as well.

On May 1^st when the U.S. Federal Reserve announced its intention of eliminating bond purchases over the course of a year, bond investors wasted no time stampeding out of fixed investments in a massive exodus that is still ongoing.

Yet the stampede out of the bond market triggered another stampede – into the housing market. Falling bonds lifted interest yields, which in turn lifted mortgage rates, prompting last minute home buyers to storm into real estate before rates rise too much further.

Four months later, it seems the low-hanging housing fruits have all been picked, and the property rush is dying down. Even more troubling, the cooling housing market is forcing many mortgage lenders to start laying off employees. Some are worried the slowdown in housing could lead to the loss of thousands of jobs from construction to mortgage lenders and all the housing supply retailers in between.

Can the housing recovery really be stalling so soon?

Assessing the Slowdown

It all rests on interest rates. Although the Federal Reserve has not changed its overnight federal funds rate – still at 0.25% for some five years now – banks have gone ahead and raised their mortgage rates anyway.

Why? Because the recent sell-off in bonds has raised the cost of money. The interest rate on the 30-year U.S. Treasury bond has already risen from 2.82% on May 1^st to 3.875% early this morning – a jump of 1.055% in a little more than four months. That’s all in anticipation of reductions to the Federal Reserve’s bond buying program.

Essentially, the bond market is telling investors that less Fed stimulus is going to make money just a little more risky and, as such, a little more expensive to acquire. So if mortgage lenders are incurring higher costs in procuring the cash they lend out, they are going to pass those higher costs onto their clients by raising the mortgage rates they charge.

But mortgage lenders have increased the cost to their borrowers a little more than the bond market has. As the graph below shows, since May 1^st (black arrow), the 30-year mortgage rate has risen from 3.35% to the current 4.57%, a rise of 1.22%. Just a little extra to cover their paperwork, you might suppose. (click to enlarge)

Source: Ycharts.com

Higher rates have prompted Wells Fargo (NYSE: WFC), the nation’s largest home mortgage lender, to forecast a drop in Q3 new mortgage applications of 29% to $80 billion worth of loans, the first reading below $100 billion in 8 quarters. The bank expects this year’s H2 applications to slump 40% below H1’s.

Even when 2012 delivered record lending profits for Well Fargo and JP Morgan Chase (NYSE: JPM), the banks knew this day would come. “We did contemplate a more normal rate environment in our longer-term targets,” Bloomberg quotes JP Morgan’s CFO Marianne Lake. “Although this may have happened sooner than we had expected.”

As in any business, when the demand for its products and services is reduced, its workforce must be also. Bank of America (NYSE: BAC) announced it would be laying off 21,000 employees and closing 16 offices by October 31^st. Wells Fargo is looking to eliminate 2,300 positions, while JP Morgan plans to cut 15,000.

Bank of America spokesman Terry Francisco indicated to Bloomberg that the reductions “reflect our ongoing efforts to streamline our facilities and align our cost structure with market realities.”

Relying on Normal Demand

Yet Wells Fargo’s CFO, Tim Slone, is not hitting the panic button on the housing recovery, despite the slowdown. “We don’t believe that the recent increases in mortgage rates are going to in any way, shape or form snuff out the housing recovery,” Bloomberg cites Slone’s assessment to a New York investor conference.

Others agree, cutting a clear distinction between the two major branches of mortgages – mortgage refinancing and home purchases. Nancy Bush, founder of NAB Research LLC, distinguishes the two markets to Bloomberg:

“We’re pretty much through the refi boom, and we don’t know yet what the purchase business will look like.”

It’s playing out as one would expect. Refinancers looking to lock in these historically low rates would naturally be the first to subside. From here on out, the market will be depending on the normal stream of buyers, which Sloan is rather upbeat on.

“When you look at any sort of statistics in the demographics in terms of household creation as well as household affordability,” he qualified, “they are still very attractive and should drive a continued recovery in the housing business.”

Indeed, as the population keeps growing, families will keep forming, and the market will always have a stream of home buyers across all market conditions. The river of buyers may swell and shrink according to economic prosperity levels. But it will always be there.

What to Expect

Consider as well that the Federal Reserve is not anywhere near ready to begin raising interest rates. All that is happening now is an adjusting of bond prices and yields to the higher cost of money once the Fed stops liquifying the money supply by terminating its monthly bond purchasing program.

Rates may still have a little further to climb in the short term. When Fed Chairman Bernanke announces the FOMC’s plans next Wednesday afternoon, look for the bond market to adjust a little lower – and yields a little higher – on the news of the Fed’s reduction plan.

But widened bond yields will quickly begin attracting investors into the bond market again, with a 3% yield on the 10-year not seen in over two years. Bond yields and mortgage rates should then stabilize down just a touch, as the uncertainty will have been replaced by actual projections.

The wild card in all of this, though, is America’s reaction to last month’s gas attack in Syria. If a strike is launched, bonds will likely rally as a safe haven for worried investors. If the strike escalates into a regional war, bonds will rise even more, with tightening yields lowering mortgage rates in turn.

If Syria is not struck, then the markets’ focus will once again fixate on the Federal Reserve. In either case – strike or no strike, war or no war – once the refinancing stampede makes it through the system, mortgage rates will stabilize, likely in the 4% to 5% area until the Fed starts raising interest rates, likely in 2015.

If you are preparing to purchase a home over the near term, you should not only enjoy steady low rates for some time, but you will also likely find property prices coming down a bit as the dust settles behind this vanishing stampede.

Joseph Cafariello

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