Research - Where Are the Home Buyers?
What are the implications of the Federal Reserve's interest rate hikes on the housing market?
Let’s start this article with a chart, the Case-Shiller U.S. National Home Price Index.
As many of us know, home prices have soared in the pandemic-era market at a much faster pace than the strong upwards trend line established in the prior decade. This is driven by several factors including historically low interest rates, pandemic stimulus, a soaring stock market, and the emergence of the work-from-home economy.
Some housing markets have experienced outsized impact from these factors, such as the California Bay Area market where wealthy tech workers with significant stock market exposure were forced/given the option to work-from-home. These workers took their wealth and fled the cities for suburban neighborhoods, propelling the suburban single family home market to insane heights where crazy bidding wars caused homes to sell for significantly over listing prices.
However, the macroeconomic environment that favored home-buying in 2021 is no longer with us, and instead appears to be rapidly shifting away towards a more sane and disciplined market. The Federal Reserve plans to raise the Fed Funds Rate from a historic low of 0.25%, dropped to this level at the onset of the pandemic, to about 2.75% by year’s end. So far, they’ve raised the rate by 0.5%, which has caused average 30-year mortgage rates to rise from a 2.65% pandemic low to 5.27% today (data from the Fed).
So, the critical question must be, where is the housing market headed given our new macroeconomic environment?
Let’s discuss.
“Don’t Fight the Fed”
The housing market forms the backbone of the US consumer economy. According to the latest report from the Survey of Consumer Finances, home equity forms the lion’s share of US household wealth at 26% (7% in stocks and bonds and 15% in retirement accounts) and about two thirds of the country own homes today.
However, unlike other sources of household wealth, home equity tends to be paired with massive debt in the form of 30-year mortgages and is thus at a much higher risk of evaporating in a heavily stressed and deleveraging economy. If US households start to see more than a quarter of their wealth disappear because they can’t meet mortgage payments, the US economy is in a world of hurt. This is what happened during the 2008 Great Financial Crisis and exactly why it was exceptionally, exceptionally painful.
As such, it is no surprise that the housing market is especially important to the foremost government agency managing the US economy, the Federal Reserve. It’s also why the Fed’s current rate hike cycle is aimed largely at cooling the housing market. The keep the economy stable, the Fed needs a sane housing market and not one filled with unsustainable bidding wars.
But Isn’t the Fed Actually Fighting Inflation?
Some might say that these interest rate hikes are to combat consumer goods (CPI) inflation and not home prices. After all, March’s CPI inflation rate reached 8.5%, the highest it’s been since 1981. Home prices are not factored into the CPI.
However, the Fed doesn’t have the tools to combat this inflation and it knows this. The current inflation is driven by geopolitical events halfway across the world with a war and strict lockdowns. US interest rate hikes can’t bring peace to Eastern Europe, nor can it slow the spread of a pesky bug in Shanghai. Consumer demand in the US, which the Fed does have a sway on, is low… very low. One just needs to look at the recent stock price performances of Amazon (down 27% since January), Wayfair (down 62% since January), Shopify (down 66% since January), and Etsy (down 52% since January) to have a sense of the US consumers’s appetite for buying non-essential goods.
However, this hasn’t stopped econ-pundits on fintwit (Finance Twitter) to call out the Fed for a seemingly hopeless attempt at quelling CPI inflation via interest rate hikes.
Perhaps the Fed isn’t trying to quell CPI inflation. The Fed recently increased interest rates by a whopping 0.5% right after a rare quarterly GDP decline confirming that they’re not aiming for lower aggregate demand. Rather, these rate hikes have a direct effect on the housing market and that’s where the Fed is really targeting.
Dousing the Flames
So where are home prices headed? Interestingly, though not surprisingly, realtors in hot regional housing markets like California are still saying that home prices are going to increase this year, though at a slower pace. They often cite the lack of supply as the key reason why (e.g. so many people locked in bottom of the barrel mortgage rates in the past two years and aren’t selling).
However, prices are set by a two-sided market, that of supply and demand. Supply might be constricted but the real story here is demand. It’s not looking great with many factors working against it:
The average mortgage interest rate rising from 2.6% to 5.2% effectively makes homes twice as expensive as before (1.026^30 = 2.22 vs 1.052^30 = 4.57). For example, a $1 million house actually costs $2.22 million in total nominal dollars with a 2.6% 30-year mortgage. With a 5.2% 30-year mortgage, this rises to $4.57 million. This is a huge increase in such a short time period and has caused mortgages to cost more than what national wages can afford.
The recent stock and bond market routs have also reduced household wealth, making it a lot harder for prospective home owners to afford mortgages.
With the country emerging from the pandemic, the work-from-home trend is moderately reversing with many companies recalling employees back to offices. This pulls demand from suburban neighborhoods to cities. Suburban neighborhoods largely contributed to the hot housing market.
The low interest rates of the last two years pulled forward and compressed several years of home-buying into two years. Most people that wanted to buy have already bought, leaving a lot fewer buyers for the years to come.
Foreign buyers also contributed to the hot housing market, but foreign economic conditions are cooling down drastically, especially in China.
Fin
No one knows for sure where home prices are headed moving forward. The trend historically has been up and naturally many people are expecting prices to continue to rise, albeit at a slower pace. However, with many macroeconomic factors shifting against the market, the foremost being the Fed dead set on cooling the market, those hoping for home prices to continue to rise are fighting a tough uphill battle.
The key question we need to ask is: “where are the buyers?”
