Wednesday, October 13, 2004

How Housing Has a Hand in Rates

Business Week

Conventional wisdom has it that bond yields influence the residential real estate market. Now the reverse may also hold

The housing sector has been one of the strongest links in the current U.S. economic recovery, while weakness in business spending and the labor sector have weighed on the overall expansion. The steady climb in home prices -- and the consequent rise in home equity -- in a world where other investment opportunities don't appear quite as safe or steady has padded household wealth, while investment in other, less tangible vehicles (like stocks) has hit a plateau.

This state of affairs has led to doomsayers regularly predicting that the housing sector is ripe for its "bubble" to burst. Sure, home prices have continued rising well past what many would consider a suitable expiration date. But expectations of the residential real estate market's demise may yet prove premature.

A BETTER QUESTION. Experts who have made the "bubble" call have banked on irrational, above-trend price gains in regional housing markets and the Federal Reserve's current cycle of interest rate hikes to trigger a buyer's strike. Yes, home values in certain regions may be stretched compared to median income growth. But demographic trends, tight inventories of available homes, and mortgage rates that are still historically low appear to be filling the void for now.

A more compelling question right now might be: How has the housing sector influenced market yields -- and vice versa? While it's typically thought that interest rate changes affect the housing market at certain key junctures, the reverse may also be true.

Take a look at recent moves in the yield on the benchmark 10-year Treasury note. It was close to 3% in June, 2003 -- the lowest level in over four decades -- after a particularly intense round of portfolio hedging by mortgage services against prepayment risk (i.e., mortgages in a portfolio being retired because of refinancing at lower rates by borrowers). That, in turn, was triggered by the U.S. brush with deflation following the start of the war in Iraq, a bruising series of corporate scandals, and the low point of the tech-sector slide.

SLIGHT MODERATION. But that's as low as yields were going to get. The 10-year note has zagged higher in two pronounced waves since the deflation scare was vanquished, first to around 4.5% in the fall of 2003, and then again nearly to 5% this past summer when the Fed began to remove some of its generous policy accommodation. The yield subsequently slipped briefly back below 4% in late September, but a survey of bond investors by JP Morgan suggests the market remains biased toward higher yields.

Yet with fixed mortgage rates not venturing beyond a percentage point of all-time lows, the housing sector continues to navigate these yield swings easily. The most recent round of housing data continued to defy the purveyors of gloom, though the sector has likely peaked with the start of the Fed's latest tightening cycle.

That slight moderation should be evident in September's existing-home sales report, scheduled for release Oct. 25. Despite the disruptions from hurricanes in the South, we expect existing-home sales to remain firm at an annual pace of 6.54 million units for the month, though somewhat off June's record 6.92 million units.

FANNIE'S AND FREDDIE'S SHADOW. Housing starts and permits data for September are more likely to feel a greater impact from Hurricane Charley and fellow storms -- the figures are expected to show a 2% drop, to a 1.96 million-unit annual pace, though this would still represent a historically elevated level.

New-home sales look a bit more vulnerable to the rough weather, with our forecast of a 7.1% slide, to a 1.1 million annual level in the September report, scheduled for release Oct. 27. Home buyers have proven remarkably resilient, and, indeed, 2004 is expected to be another banner year for the housing market.

Overhanging the robust housing market are the actions of housing agencies Fannie Mae (FNM ) and Freddie Mac (FRE), which facilitate the secondary mortgage market by purchasing loans and mortgage-related securities from lenders and other institutions. Though the agencies have widened the opportunity for home ownership, their enormous size has prompted them to engage in hedging (i.e., purchasing Treasuries, or interest rate swaps, options, and other derivatives) to mitigate their exposure to rate risk.

FEELING A CHILL? Fannie's and Freddie's hedging activities, along with those of other mortgage institutions, have temporarily exaggerated movements in the underlying Treasury market. Hedging is enormously complex, and when institutions purchase or sell large amounts of Treasuries or other securities, it may in turn may trigger yield movements.

Indeed, the latest dip in the 10-year note below 4% was generally presumed to be an attempt by shorter-term leveraged funds to cash in on a demand surge for the benchmark issue. Those funds may have sought to lock in profits by selling to some ready buyers: Mortgage servicers rushing to hedge against lower rates by buying longer-dated government debt to lengthen the average maturity of their portfolios. Yields subsequently bounced back to highs near 4.25% by Oct. 4.

Bond-market bulls may continue to feel the chill. The investigation of Fannie Mae's accounting practices, its retrenchment away from market-making, and regulators' requirement that it boost its capital reserves suggests that the rate of its mortgage purchases will slow. Indeed some analysts speculate that the agency might even have to liquidate $100 billion in assets to rebalance its ratios.

While rates backed down to around 4.1% in the wake of a fresh surge in oil prices, risk remains for an eventual run back toward 5%. But even if the 10-year note's yield touches that level -- and mortgage rates move to around 6.8% in sympathy -- the latter remain low by historical standards. And that means the housing sector should be able stay on its feet for some time to come.