After a period of low interest rates that fueled housing market, the Federal Reserve is meeting on March 14-15 with the stated goal to raise the benchmark interest rates from near zero. Many are saying that this will lead to softening in the real estate market, if not a price pullback. The reasoning is that the mortgage rates are expected to go up as well, increasing monthly payments for borrowers and diluting the staying power. While it is true that if mortgage rates go up it will indeed be harder to afford homes at the same price as now, it is important to keep in mind that the mortgage rates do not really correlate with the benchmark interest rate set by the Fed. This rate is simply an overnight borrowing rate between the banks. Instead, the mortgage rates better correlate with the long-term maturity bond rates, such as a 30 yr treasury bond. The reason for it is that the mortgage notes are now sold on a secondary market as mortgage-backed securities and they directly compete for investment dollars with similar fixed income securities, such as treasury securities. There are many types of treasury securities: short term (less than 1 yr – called T-bills), medium term (2yr - 10 yr – called T-notes) and long term (20, 25 and 30 yr maturity – called T-bonds). The actual yields on all these securities varies with risk – short term - lower risk, and lower yield, long term – higher risk and higher yield. These yields vs. maturity can form a curve, called the yield curve, that is used by investors to estimate the level of risk mispricing.
The longer terms bonds are a relatively new product and long term data is not available. In contrast, the 10 yr note yields go back as far as 1871 and could be used as comparison to case schiller home price index, which could be traced back to 1890. While the 10 yr treasury yield does not equal the 30 yr mortgage rates, the trends in 10 yr yield is a sufficient approximation for trends in 30 yr fixed rate mortgage. Here we look at the history of housing price index (log-10 scale) and comparing it to the interest rate of a 10yr treasury note.
Normally, across podcasts, blogposts and YouTube videos we hear that recent parabolic rise in housing prices has been attributed, in part, to a massive drop in interest rates going from the Paul Volcker era of the high interest rates in 1980 up to now, when we are in the zero interest rate environment since 2008 (excluding rate hikes from 2016-2018). Indeed, if we look at precipitous drop in the 10 yr treasury rates (on linear scale) and skyrocketing housing index, we may reach the same conclusion as well. We may decide, that, given how sensitive our overleveraged economy has become to slight upticks in the interest rates, we may indeed expect another housing crash if the Fed raises rates even a little. However, zooming further out, shows us a different picture.
Panic of 1873. After the economic boom post Civil War, a lot of speculative investment was made into the railroad industry, which was the dominant industry at the time. However, this investment was overleveraged and did not offer immediate or short-term returns. In addition, a series of events, like 1871 Chicago fire and the equine influenza outbreak caused a series of defaults that lead to the panic of 1873. This caused a downward pressure on the 10 yr treasury yields, leading them to fall from 5.58% to 3.62% in the mid 1880s. In 1893, another economic crash happened, bringing the rates further down from 3.75 to 3.15% in 1900. As the bond yields dropped significantly from over the course of 26 years, the housing index (measuring from 1890) rose only by 5%.
Early 20s Century. The early 1900s were rocky – from the panic of 1908 to WWI. As the economic conditions improved in the early 20s (the roaring 20s), the bond yield saw expected come back from the lows of 3.10% in 1900 to the peak of 5.09% in 1921. In addition, the Central Bank of the United States, named the Federal Reserved (or “The Fed”), was already established in 1913, and it began open market treasuries sales and rates hike to tame rising inflation. At the same time, together with the increasing rates, the housing index continued increasing as well from 3.85 in 1900 to 5.99 in 1921. Even though the economy started seeing heightened market exuberance and the downside risks began to increase, The Fed, while knowing full well the risks of easy money, inflation and speculation, continued to purchase the treasuries. During the January 14, 1924 meeting, the open market committee notes: “While the situation clearly contains a threat of inflation, the time has not yet come to sell securities… We should continue to acquire more as far as we can do so…”. This is just one example, that makes some say that, deliberately or not, the Fed has contributed to the creation of the Great Depression. In a free market, when the economy is doing well and there is no need for safety of treasuries, investors will sell treasuries and re-invest elsewhere, leading to the yield increase – the opposite of what happened in the 20s. Now that the Fed is interfering with the free market, one cannot predict what would happen with the yields, regardless of the state of the economy, unless that one is a Fed insider. From 1921 until the peak euphoria in 1929, while the housing stayed mostly flat (3% drop from 1921 to 1929), the bond yields declined tremendously from 5.09% to 3.60 %.
After the stock market peak in 1929, and subsequent Great Depression, the housing market dropped from by massive 25% by 1933 (such drop is only paralleled by GFC in 2008 in the recorded history!) During this time, the treasury yields stayed mostly flat. From 1933 to 1941, the thick of the World War II, the housing market recovered and moved upwards, while the 10 Yr Treasury rates cratered from 3.31% to 1.95%. The reasons the rates moved even further down in the mid 30s is the increased demand on treasuries due to the new legislation aimed at stabilizing the banks and requiring that the banks hold government securities as reserves. This fueled the demand for treasuries, as well as the Fed policy aimed at creating more liquidity in the market by purchasing treasuries with their printed money.
Post WWII. From the creation of the Fed in 1913 to 1940, the Central Bank has learned from their experiments on the American economy and also learned the cause and effect relationships between manipulating the markets through securities purchases/sales and the economic health. These manipulations were called “monetary policy” and were used deliberately to stimulate or to cool down the economy since then. During the WWII and the recovery period of 1950s, there was a need for credit to conduct warfare and to rebuild the infrastructure, which the Fed accommodated by keeping the yields low and flat until mid 50s at ~2.5% for the 10yr treasury. During this time, as we discussed before, the housing market had a parabolic 300% rise due to new loan options and developing mortgage market.
From the mid 50s to late 60s, the yields continue to inch up as the Fed tried to get ahead of the inflation that was brewing due to massive money creation during the WWII and the recovery period. Followed by the Nixon Shock in 1971, when the US Treasury knew it could no longer exchange dollars for gold (too many printed dollars, too little gold), the gold standard was “temporarily” suspended. The public sentiment has shifted drastically, as people realized that now, the paper dollar is not backed by anything, which lead to massive capital flight to assets and everyday purchases, fueling inflation to unseen levels of 15% in the end of 70s/early 80s. In addition, gas shortages (which now could be called “supply chain issues”) also contributed to rising prices. As a measure to control inflation, the Chairman of the Federal Reserve Paul Volcker raised the fed funds rate to almost 20% in 1981, which resulted in the 10 yr treasury yield of 14.5% later in 1982. During this time, the housing continued to appreciate due to Freddie Mac creation, increasing homeowners’ monthly payments with each year.
1982 marks the height of the treasury yields. The next 40 years will see an unprecedented drop of Fed funds rates and also the treasury yields. From 1982 until 2003 the yields dropped from 14.5% to 4.05%, while the housing index skyrocketed by almost 300%. The no money down housing purchases and no income, no job, no assets (the NINJA) loans became popular, the housing continued to skyrocket while the yields increased modestly until 2007. After 2007, the housing crash registered 27% drop in the housing index (such level seen only during The Great Depression), and the Fed began accommodating the economic recovery through zero interest rate policy (ZIRP), and massive treasury purchasing programs. After 2011, as the housing market showed parabolic recovery, the Fed continued the endless QE cycles, making markets so high on easy money, that in 2013, when Fed announced that they will slow down the rate of purchasing (taper purchasing), the market experienced the “taper tantrum”. From 2012 until 2022, the 10 yr treasury yields stayed mostly flat (the modest hikes in 2018 and drops in 2020 canceling each out).
So where are we now? Today, March 4, 2022, we are seeing the housing market at its highest in history. The fed funds rate at near zero, 10 yr treasury at historic lows, rising slowly from the bottoms of 2020, and the 30 yr fixed mortgage rates at historic lows as well (and also slowly rising). Throughout history, while there may have been a short term softening of housing with rising rates, the overall trend is a complete lack of correlation between the two. The primary reason for that is that the input factors driving securities yields and housing prices are not necessarily the same.
Conclusions. The driving forces behind housing market are very complex. There are many factors, however, generally supply and demand hold true in housing on the buying and selling side, and staying power plays a role on if someone has to sell at a loss. Staying power: income, reserves and effective management. What we sometimes miss, is that the same is true for bond (mortgage) market. It also depends on many factors, fed funds rate being only one of them. Sometimes they move together with housing prices, sometimes in the opposing directions, and sometimes they are completely uncorrelated. While the fed funds rate is set only by the Fed, the treasury yields depend on many more factors, including FOMC operations (Fed buying and selling securities), as well as institutional and individual investor behavior. Whether the fed funds rate hike on March 16, 2022 (if it happens) will lead to softening in the housing market - is only a guess.
