Recent jolts to the economy stemming in part from an intensified trade war with China have worried markets and resulted in a significant decline in interest rates as investors have shifted from equity to bonds. Lower interest rates present an opportunity for the housing market, which has failed so far to respond energetically to this positive development due to prior affordability headwinds. This analysis provides an overview of current economic conditions and what is required for a more robust housing response to lower rates, including an increase in single-family permits.
Interest rates continue to decline, as investors reset their expectations of both near-term economic growth and their tolerance for risk. Most analysts, including the NAHB forecast, expected economic growth to be slower in 2019 than 2018. However, rising trade concerns are adding uncertainty to the outlook, and uncertainty causes a flight to quality for investors. The corresponding portfolio adjustments produce declines in stock prices and increased demand for bonds. Higher bond prices, in turn, yield lower interest rates. That’s what we are witnessing in financial markets this week.
Consider the 10-year Treasury, my preferred “if you have only one economic variable to examine” measure of market conditions. The interest rate on the 10-year Treasury began 2019 at 2.69%. It experienced a slow decline through May, losing about 25 basis points. During the last part of May, the rate lost 30 more basis points, holding just above 2% for two months as markets priced in growth concerns and a more dovish policy stance from the Federal Reserve. Over the last week, with the trade dispute with China looming larger, the 10-year rate has lost more than 30 additional basis points, coming in today around 1.7%.
Remarkably, these historically low domestic rates are relatively high on the global stage. The yields on 10-year bonds in Japan, France and Germany all have negative interest rates. Some of this is due to demographics, with a large number of baby boomers seeking lower risk investments during their retirement years. Some of this effect is due to businesses that are required to hold bonds in certain market environments. The combined result is an increased price for these bonds and lower rates.
However, despite the approximate 100 basis point decline in the US 10-year, which should reduce the average 30-year fixed rate mortgage to around 3.5%, housing activity has not responded as robustly as history would suggest. In part, this lack of response is due to the surprise associated with this decline, so markets will need time to adjust. For example, these rates are below NAHB’s forecast from the start of 2019. The lack of a home sales response is also due to the fact that rates are lower for the wrong reasons. These declines, while a positive for the cost of buying a home, are occurring due to the uncertainty produced by trade and growth concerns.
More fundamentally, lower rates by themselves are not sufficient to generate a significant increase in home construction today because housing affordability is a function of rates, prices/costs, and incomes. And due to the significant supply-side headwinds of the last few years (worker shortages, materials and regulatory burdens, chief among what I’ve called the “5 Ls” – labor, lots, laws, lending and lumber), construction costs have outpaced income growth, leaving housing affordability at the start of 2019 near a 10-year low.
The lack of an economic impact of lower rates is a broader challenge for the Federal Reserve. The dual mandate requires warding off inflation and working for maximum employment. However, if lower rates cannot generate significant additional economic activity by themselves (with housing as an example), the power of monetary policy is weakened. Moreover, the Fed is trying to keep up with a bond market that is producing lower rates due to concerns over trade and other policies that the Fed cannot directly influence.