Collateral damage

Bottom Line

Although well behind the curve, the Federal Reserve has finally found religion in combating the worst inflation in 40 years. Chair Jerome Powell publicly retired “transitory” in early December 2021, and the central bank completed its monthly bond-buying taper in March. The Fed then hiked interest rates in its last three policy-setting meetings—a quarter point in March, a half point in May and three-quarters of a point in June—and has begun quantitative tightening.

To be sure, policymakers should have orchestrated these changes at this time last year, as inflation began to look like a hockey-stick in the aftermath of Congress passing the $1.9 trillion American Relief Plan. While belated, the withdrawal of accommodation should help to cool the white-hot housing market.

Interest rates are key Benchmark 10-year Treasury yields have soared from 1.5% at the end of last year to 3.5% last week. Not surprisingly, 30-year fixed-rate mortgages have followed suit, doubling to 6% over the past six months, the highest level in nearly 14 years. 

The Fed began to shrink its bloated $9 trillion balance sheet this month, letting $47.5 billion in securities roll off in June, July and August ($30 billion in Treasuries and $17.5 billion in mortgage-backed securities, or MBS). Starting in September, it plans to accelerate that pace to $95 billion monthly ($60 billion in Treasuries and $35 billion in MBS). Reducing its MBS holdings should result in higher mortgage rates, as prices decline.

Home prices peaking? With an estimated shortfall of about four million houses in the U.S., and with very strong demand for housing since the Covid pandemic hit more than two years ago, prices have soared to record highs. 

The median price for existing home sales, which account for almost 89% of all home sales in the U.S., rose in May 2022 to a record high of $407,600. Over the past 23 years since record-keeping began, existing home prices have risen at a compound annual growth rate (CAGR) of 5%. But since the pandemic hit in January 2020, prices for existing homes have surged at a CAGR of 20% annually, quadrupling the long-term average gain. 

The median price for new home sales, which account for slightly more than 11% of all home sales in the U.S., rose in April 2022 to a record high of $454,700. Over the past 59 years since record-keeping began, new home prices have risen at a CAGR of 5.7%. But since the pandemic hit in January 2020, prices have accelerated to 15.4%, nearly triple the long-term average. 

What caused housing prices to soar? Aside from the supply/demand imbalance, low interest rates, a surging Fed-induced wealth effect and overly generous fiscal stimulus pushed costs up sharply. Lumber prices leapt by more than six times to their peak, while copper and steel prices more than doubled and tripled, respectively. Those commodity prices have started to ease in recent months. Remnants of skilled-labor shortages (carpenters, electricians and plumbers) from the bursting of the housing bubble in 2007-09 resulted in strong double-digit wage gains, as home builders attempted to staff up. 

Confidence and savings rate down This morning, the final Michigan Consumer Sentiment Index for June plunged to a new 44-year low of 50 (half its pre-pandemic high of 101) due to rampant inflation worries. The NAHB’s Housing Market Index fell in June to a two-year low of 67, down from a record high of 90 in November 2020. Typically, it rises into the fall, before rolling over during the seasonally slow winter months. With the personal savings rate plummeting from 26.6% in March 2021 to a 14-year low of 4.4% in April 2022, consumers are less willing and able to afford these higher labor, commodity and transportation costs.

Labor market starting to slow? Initial weekly jobless claims, an important leading indicator for the labor market, have spiked almost 38% over the past three months to a 5-month high of 229,000 claims. The smoother 4-week moving average rose 31%. Yesterday’s data was the important survey week for the June nonfarm payroll report, to be released July 8, so it appears as if the labor market also is cooling.

GDP estimates trending lower The housing market accounts for about 3.5% of GDP, and we reduced our GDP estimates last month to 2.4% for this year (versus 5.7% in 2021) and to 1.5% in 2023. But there is probably downside risk to those estimates, as recession worries have intensified. 

Cracks in the foundation Existing home sales have declined in each of the past four months through May, down nearly 17% over the period. New home sales in May rose by a surprisingly strong 10.7% month-over-month, perhaps a last spasm of buying before interest-rate increases got out of control. Despite that, new home sales have declined 17% since December 2021. Pending home sales declined each of the past six months through April, and housing starts in May have fallen to their lowest levels in a year. Mortgage foreclosures surprisingly leapt to 0.53% in the first quarter of 2022, up from 0.42% in the fourth quarter of 2021, a new 35-year low.

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