As safe as houses
The Fed is walking an impossibly thin tightrope between controlling inflation and collapsing the housing market.
Last month, the Federal Reserve Bank of Dallas sounded the alarm on the housing market. “There is growing concern that U.S. house prices are again becoming unhinged from fundamentals,” wrote their economists in a piece called Real-Time Market Monitoring Finds Signs of Brewing U.S. Housing Bubble. They are right, if not a bit late to the party. Over the last 18 months, your author has penned nine pieces on the growing housing bubbles worldwide, analysing everything from what is causing them to how big they are.
During the Federal Open Market Committee’s (FOMC) March meeting, Fed officials suggested it “would be appropriate” to consider selling mortgage-backed securities (MBS) to combat rising inflation and cool the housing market in the U.S. They said that in the context of rising mortgage rates and shrinking refinancing volumes, getting these securities off their balance sheet made sense but that any decision “would be announced well in advance.” This announcement was enough to get markets moving. The 30-year fixed-rate mortgage, which had already climbed from 2.77% in August last year to 3.85% before the March meeting, has risen to above 5%, the highest rate since 2011.
In the U.S., mortgage securitisation, and the Federal Reserve’s interest rate suppression agenda, have distorted financing costs. By pooling risk, removing it from the banking sector, and putting it into the hands of private investors, the financial system has been made more robust. But the market has become so big, and the Federal Reserve such a large part of it, that any reversal would crush the housing market. According to the Securities Industry and Financial Markets Association (SIFMA), as of Q4 2021, the total U.S. MBS market was worth about $12.2trn. The MBS market has grown to 21% of the total value of all U.S. housing stock and 68% of the entire mortgage market. Securitisation has run rampant.
Since the global financial crisis (GFC) in 2008, particularly during the pandemic, the Fed has been a considerable buyer of these securities. According to their latest H.4.1 release, they currently hold $2.7trn worth. The goal of buying these assets was to suppress interest rates on mortgages, particularly long-term ones. It worked. The more involved the Fed got in the MBS market, the lower real mortgage costs, the difference between the 30-year fixed-rate mortgage and 30-year break-even inflation, dropped. By the start of this year, the Fed held 22% of all mortgage-backed securities, and real mortgage costs were 0.5%.
Once the Fed gets out of the MBS check-out line, only private investors like pension and insurance funds will be left shopping. With high levels of household debt to income–I estimate it to be 186%–and inflation expectations picking up, these investors will demand higher returns as compensation for these risks. Markets have already priced in the Fed’s check-out-line sidestep. Investors’ expectations that the Fed won’t be an active buyer of MBSs anymore is why mortgage rates have increased dramatically over the past few weeks. Using the 2014 to 2018 period as a proxy for when the Fed maintains but doesn’t expand its MBS position, the average long-term real mortgage rate was 2.5%. With long-term break-even inflation at 2.5%, a 30-year fixed-rate mortgage should cost about 5%, which is where it currently sits according to the Federal Reserve Bank of St. Louis.
If inflation moves higher and the Fed starts actively trimming its MBS position, real rates will rise again and crush both sides of the market. Financing will dry up for builders looking for construction loans and home buyers looking for mortgages.
The housing market has always been cyclical but has become hooked on low and declining interest rates. In this fight, the central bank has been their friend, stepping in to lower rates with new money whenever needed. But the Fed is walking an impossibly thin tightrope between controlling inflation and crushing the housing market. Unless they pull off something never-before achieved, the “don’t fight the Fed” adage might have a new, negative meaning for house prices.