Rising Rates May Help Housing (For Now)

What went down must come up.

So we at Palisades Hudson, along with others, have said for the last few years about interest rates. Now we are beginning to see the rise we expected. There are a few reasons for this, the most prominent being an improving economy and the anticipation that the Federal Reserve will begin tightening its super-loose-money policy relatively soon.

The Labor Department came out with another fairly strong jobs report at the beginning of July. The economy gained 195,000 jobs last month, which, while not exceptional, was better than expected and shows continued progress. The official unemployment rate held steady, at 7.6 percent. Last month also included Ben Bernanke’s much-discussed press conference, reminding investors that the Fed will ease off the loose-money throttle as the economy continues to gain momentum – and that the turning point is not necessarily far off.

These factors are beginning to pull our super-low interest rates upward. Just two months ago, the rate on 10-year Treasury bonds (which are a benchmark for many mortgage rates) was 1.62 percent. It recently touched 2.70 percent before falling back to just below 2.60 percent late last week. Almost in lockstep, mortgage interest rates have risen by about 1 percentage point in the same period.

Typically, you would expect higher mortgage rates to cool the housing market. As mortgages get more expensive, buyers are typically less willing to buy more and bigger homes. Yet in this case, at least in the short term, I suspect rising mortgage rates will have exactly the opposite effect, prompting buyers who have been waiting to rush into the market. In fact, Fannie Mae’s June National Housing Survey indicated that 72 percent of respondents still thought it was a good time to buy a home, despite the fact that 57 percent of respondents expect mortgage rates to increase over the next year.

So why would we expect rising interest rates not to hurt the housing market’s recovery, and perhaps to even help it along?

During the recent downturn, many sellers held property off the market awaiting a rebound rather than selling at fire-sale prices. At the same time, many buyers waited in order to be sure prices had stopped falling. (It seems like they have, incidentally. The S&P/Case-Shiller index, which tracks home prices in 20 U.S. cities, has risen a little more than 12 percent in the past year.)

Procrastinating buyers and sellers assumed that mortgage rates would stay low for a long time, if not indefinitely. As rates rise – though they are still low by historical standards – those who were playing the waiting game likely feel pressure to jump back into the housing market. Buyers will want to hurry to take advantage of still-low mortgage rates before they rise even more. Sellers will seek to benefit from the fairly strong market before higher mortgage rates undercut housing once again. It is not unreasonable to expect the housing market to pick up in many areas, at least for the immediate future.

At the same time, bond prices have fallen sharply since interest rates began to rise. They have the potential to fall even more. The risk of a bond market collapse is real, but it isn’t new. Even for savers, who have been arguably the biggest losers in the low interest rate environment, rising interest rates may not signal much benefit just yet.

But we cannot arrive at our goal of a normal economy – one in which savers have reasons to save, businesses can borrow money in order to invest and expand, and banks are in the business of meeting the needs of both – if the central bank keeps artificially depressing interest rates. The longer the Fed keeps up its financial repression, as these conditions have come to be called, the more interest rates act just like other forms of price controls: The official price of goods (in this case, money to borrow) is cheap but the supply is nonetheless scarce (reflected in the difficulty would-be borrowers have in actually getting a loan).

Our journey toward normalcy is likely to be a long hike, with some pretty unpleasant moments along the way – most of all for bond investors who thought they could get out before prices tumble. But it is a journey we have to make sooner or later. Now looks like as good a time as any to begin.

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