Behold Goldman's Explanation For Why The Surge In Mortgage Rates Will Be A "Fairly Small Threat" To Housing

Goldman, very much in sticking with their newly found fame of Wall Street's biggest bullish flipflopper, has decided to pen a lengthy missive, explaining why the recent surge in mortgage rates, contrary to logic, will actually not have much if any impact on housing prices. The kicker: per Goldman, rising equities creates a wealth effect. "Equity prices are moving the other way.  One key reason why US consumers retrenched in 2008, besides the unpleasant novelty of widespread, steep home price declines, is that equity prices were also falling sharply.  However, equity prices have risen more than 20% since mid-year, and our equity strategists expect significant additional appreciation in 2011.  Under these circumstances, the bar for a home-price-induced consumer pullback is fairly high." Presumably the very same middle class which is the backbone of home purchasing will somehow forget that they have taken money out of stocks for 32 weeks, and splurge on a new home with the proceeds. And the funny thing is that even the dumb plebs realize that a 1% rise in rates is the equivalent of a 9-10% drop in purchasing power, as that is money that will go to covering interest payments over the 30 year life of a mortgage. And should rates continue rising without any indication of stoppage, all buyers will have to factor the fact that sellers are increasingly more desperate into their purchasing decisions... Which means another leg down in bids. But that is the logical, and simple, explanation. For a much longer one, which could have come straight from some Federal Reserve research desk, read the profound ruminations by Ed McKelvey below.

Fixed-Income Selloff is a Fairly Small Threat to Housing-Related Activity

In the wake of the sharp selloff in US fixed-income markets, we address questions now surfacing about the vulnerability of the US housing sector to the interest-rate increases.  These developments are clearly not friendly to the outlook for housing and mortgage borrowing, but the likely effects are not large enough to warrant a change to our December 1 upgrade or to forestall upcoming revisions that will incorporate the tax deal now being wrapped up in Congress.
 
The sharp selloff in US fixed-income markets has spawned questions about the vulnerability of the US housing sector to higher interest rates.  Could renewed weakness in housing activity, mortgage borrowing, or home prices undo some of the upward revision to the 2011 growth outlook that we announced on December 1, or could it forestall the further upgrade that is waiting in the wings as Congress wraps up its consideration, and probable passage, of the tax compromise announced on December 6?  These questions take on added importance in light of indications by our colleagues in the global markets group that their forecasts for longer-term interest rates are under review for a probable upward revision.  (See “E-bonds Can be Part of the Solution,” Global Markets Daily, December 9, 2010.)  Several weeks before, they correctly pointed out that bond yields had seen their lows in early October.
 
Although the bond market selloff is obviously not friendly to housing-related activity, we do not think it poses a material threat at this time for reasons spelled out in this daily comment.  Before addressing the specific issues, we emphasize two general points:

1.     While the selloff has been unexpectedly sudden and sharp, it is mainly a reversal of rate declines that occurred only recently.  For example, while the current 3½% yield on 10-year Treasury notes is about 110 basis points (bp) above its early October low, it is below the levels that prevailed in the first quarter of the year and “only” about 50bp above its mid-year level at mid-year.  Likewise, rates on 30-year conforming conventional mortgage loans—at about 4.8% currently—are below the 5%-plus rates of the first quarter and only about 25bp above mid-year levels.
 
2.     The selloff reflects, to a considerable degree, the improved US outlook, evident in both the recent data and in the impending fiscal package.  This is clear in the fact that the largest rate increases occurred following strong data points and the announcement of the tax deal last Monday, and it is a point stressed by our global colleagues in the aforementioned forecast update.  

In considering the issues specific to the US housing sector and related activity, we find it useful to identify three channels by which higher rates can affect economic activity: (1) reductions in sales of new and existing homes, which in turn depress housing starts and residential investment; (2) the potential for reduced sales to aggravate the decline in home prices that has resumed in recent months, which in turn could trigger renewed retrenchment in real consumer spending; and (3) a reduction in the number of mortgage borrowers who are apt to refinance their mortgages.    In the past, waves of refinancing have helped boost consumer spending by reducing households’ interest expense or, for a while earlier this decade, by allowing homeowners to withdraw equity from their homes.
 
On the first (homebuilding) channel, the damage is apt to be minimal because:

1.     Starts are already at a frictional low.  For at least the past three years, we have argued that US housing starts would drop to frictional lows and essentially stay there until the huge overhang of unoccupied housing had been whittled down to more normal levels.  (See Ed McKelvey, “L is (Still) for Housing,” US Economics Analyst, 10/43, October 29, 2010, for the latest expression of this view.)  The data have supported this view.  For example, while starts rose about 4% overall in November and nearly 7% in the single-family sector, they remain below 600,000 and 500,000 (annual rates), respectively.  Since we believe that the current rate of production in this sector is determined mainly by differences between the types (and locations) of housing prospective buyers demand and the available supply, we also think it will be fairly insensitive to macroeconomic determinants of housing demand, such as mortgage rates.
 
2.     Sales have not risen significantly in response to the rate declines.  In fact, sales of new homes reached a new all-time low after the homebuyer tax credit expired this past April, and they have remained mired at or near this level since then.  This is important because it is the sales of new homes that send the signal to builders to boost construction.  Sales of existing homes have done better, but only relative to a sharp payback following the expiration of the tax credit.  Since the recent rate increases have essentially just undone the declines from earlier months, it is hard to see why sales should drop significantly further from current levels.

Turning to the second (home price) channel, we have already recognized this as a significant risk to the US outlook—in fact, the biggest now that the prospect of a fiscal stalemate in Washington is off the table as a threat to near-term growth.  That said, the incremental risk associated with recent interest rate increases appears too small to take the scenario of renewed retrenchment in consumer spending on board as part of the central forecast.  The key points in this regard:

1.     The rate increases that have occurred thus far should have little, if any, marginal effect on home prices.  As noted above, the interest rate on 30-year fixed-rate conforming loans has risen about 60bp in recent weeks.  Our house price model suggests that this would reduce the Case-Shiller price index by only about 1 percentage point over the next four quarters.  (See Jari Stehn, “House Prices Have Not Bottomed Yet,” US Economics Analyst, 10/22, June 4, 2010.)
 
2.     Equity prices are moving the other way.  One key reason why US consumers retrenched in 2008, besides the unpleasant novelty of widespread, steep home price declines, is that equity prices were also falling sharply.  However, equity prices have risen more than 20% since mid-year, and our equity strategists expect significant additional appreciation in 2011.  Under these circumstances, the bar for a home-price-induced consumer pullback is fairly high.

Finally, the third (refinancing) channel should have minimal effects as well:

1.     Refinancing has been muted.  Although applications for refinancing surged in response to earlier declines in mortgage rates and have since tailed off, the volume of loan originations for this purpose has remained low through the third quarter, at about $300bn (per quarter).  It is possible that the next report (due in late January) will show more such borrowing, in lagged response to the surge in applications.  However, it is also clear from the exhibit below that the relationship between the two has changed.  After a long period of strikingly similar movement, from 1990 through 2003, the two broke apart in 2004.  From then through most of 2007, the dollar volume of originations was high relative to applications, probably reflecting looser lending standards and the consumers’ increasing reliance on liquefying home equity to keep spending in the face of anemic income growth.  Indeed, mortgage equity withdrawal (MEW) was a key theme of our research during much of that time, both as an explanation of why consumer spending was strong when income was muted and as a looming threat to growth.  With the subsequent tightening in lending standards and the opportunities for MEW vanishing as home prices tumbled, the dollar volume of refinancing originations has fallen relative to applications.

2.     The potential for reduced refinancing to constrain consumer spending is therefore small.  Unless consumers have suddenly succeeded in restarting the MEW engine, which seems highly unlikely, the potential for reduced refinancing to constrain growth in consumer spending is quite limited.  We illustrate this by assuming that refinancing originations disappear altogether over the next four quarters—an obviously extreme assumption—and showing that the effect on consumer spending would be to reduce it by less than 0.1%.  The calculation is as follows: We assume that borrowers are currently saving 100bp on average by refinancing.  With refinancing at $300bn per quarter, this implies $12bn in reduced pretax interest expense that could not be realized if such activity disappeared.  If we further assume that the average tax rate for borrowers doing the refinancing is 25%, then this translates into $9bn after taxes, or about 0.09% of consumer spending (assuming still further that consumers do not reduce saving at all to maintain consumption standards).
 
In short, while increases in long-term interest rates have been larger and faster than we thought likely, the likelihood that this selloff has a material effect on US housing activity is quite low.  In turn, since housing is the main (but certainly not the only) avenue through which interest rates have affected growth, we are not too concerned that the backup is undoing the argument for firmer economic activity in the year(s) ahead.

Comments

[stoverny]

More proof that the rich are the only ones who matter.  Keep ramping those equity prices, and keep screwing savers. retirees, and those on fixed incomes.  The vampire squid salutes you.

[DaveyJones]

Goldman is "contrary" to a lot of things.

[Thoreau]

What housing?

[TheProphet]

Ummm... what wealth? If you stayed in the whole time, you are still down more than 20% from the peak... which means you have to gain another 25% to get even.

[Rainman]

Housing depression must continue due to the Holy Trinity factors. Prices must come down or household incomes must go up or both. Interest rate is either a headwind or a tailwind, but the critical issue is that pricing and incomes are a decade out of whack.

[hidingfromhelis]

...a 1% rise in rates is the equivalent of a 9-10% drop in purchasing power...

The artificially low rates were the only life support keeping housing somewhat alive.  There's no way that the increases in mortgage rates aren't going to have a huge negative effect on home pricing/sales volumes, let alone the effect on consumer spending via the MEW ATM.  But then again, I'm not an economist...what do I know?