The US Housing Market Won’t Be Cooling Anytime Soon. Here’s Why.

Last summer as the US housing market heated up, we looked at what was causing home prices to skyrocket – and with high prices persisting, the question is just as relevant today. As the Fed embarks on reducing liquidity in financial markets and concerns mount about rising mortgage rates, we’re looking at what the data and recent history say about how the Fed’s actions could influence home prices.

The lack of homebuilding coming out of the global financial crisis created a housing shortage amid demographic changes and a ramp-up in household formation, and since then, the Covid crisis and resulting exodus from urban areas exacerbated the shortage of single-family houses for sale. The surge in demand caused home prices to shoot up.

Has home price appreciation since cooled off, and has the supply of homes for sale normalized somewhat to help alleviate the bidding wars? In short, no. As the chart below shows, the supply of homes for sale has plunged to a multi-year low of 1.8 months (see navy line). This trend has boosted home prices still higher, as the green line shows. And we note that while pricing data may appear to have peaked, the latest reading still shows an 18.8% year-over-year increase.

US Inventories Plunge as Housing Prices Skyrocket

Source: Bloomberg, US Existing Home Sales Months Supply NSA, as of 8 February 2022.

If the inventory of homes to buy is insufficient and if home prices are too high, the question becomes, why wouldn’t would-be homebuyers just choose to rent and wait for the market to normalize? Trends in vacancy rates provide a clear indication. As the chart below shows, vacancy rates of homes and apartments are at a 30-year low, so even those who never planned on owning a home are feeling squeezed in the rental market.

Vacancy Rates of US Homes and Apartments Are at 30-Year Lows

Source: Bloomberg, Rental Vacancy Rates US Houses and Apartments, as of 8 February 2022.

What could drive vacancy rates so low? We see several reasons. One is simply a ripple effect of the lack of homebuilding coming out of the financial crisis. Added to that, the pandemic launched a “work from anywhere” exodus from urban hubs to more remote areas that offered more space. Yet not all of those who opted to relocate to other regions sold their urban homes or terminated their leases; they simply added a second property, further contributing to the overall reduction in vacancies. With mortgage rates hitting all-time lows during the pandemic, homeowners found it easier to finance a second home; and with rentals scarce, they were able to easily turn second properties into rentals.

Will rising rates and the recent increase in 30-year mortgage interest rates cool off housing prices? We hear this question a lot. It seems natural to assume that if mortgage rates go higher, then it becomes more “expensive” to buy a house, and this should cause home prices to fall. The reality, though, is that mortgage rates alone do not drive home prices. Other factors, such as the overall economy, unemployment rates, and loan underwriting policies have a much bigger influence on home prices. A look back at 2018 (as illustrated in the graphic below), the last time in recent history that mortgage rates rose over the course of an entire year, is a case in point. The mortgage rate rose about 1% from January to November of that year. But home prices actually rose about 6% during that period.

Mortgage Rates Versus Home Prices: Not a Linear Relationship

Source: Bloomberg, S&P CoreLogic Case-Shiller US National Home Price NSA Index. As of 8 February 2022.

Lastly, will the conclusion of the Federal Reserve’s purchases of mortgage-backed securities (MBS) reverse the pace of home price appreciation? We think there is a big misconception about how much the Fed’s MBS buying contributed to escalating home prices. First, the absolute nominal level of interest rates determines mortgage rates. The Fed’s purchasing of $3.2 trillion of Treasury bonds, in conjunction with $1.3 trillion of MBS, caused interest rates to plunge and mortgage rates to fall to record lows. Buying MBS alone does not make mortgage rates go lower.

So what will the impact of the Fed reducing its MBS purchases do for mortgage rates? When the largest buyer of MBS curtails its buying, the reduced liquidity in the market will cause spreads on these securities to increase in the secondary markets. This could translate to about an additional 0.25% of interest that a borrower would have to absorb. The key takeaway is that if Treasury yields were to rise 1% in 2022 or beyond, mortgage rates would likely move in lockstep. Mortgage rates do not rise as a direct result of the Fed reducing its MBS purchases.

When considering what might finally cause the housing market to normalize, it’s impossible to pinpoint a single factor; there is no switch that can be flipped to stop home prices from going up and vacancies from falling. We believe the only answer is time. Higher mortgage rates may make it harder for someone to purchase a second home. Time is needed for new homes to be built to bring needed supply into the market. Time is needed for pandemic-related economic stimulus to run its course, and perhaps for disposable income to fall; and higher inflation could cause potential homebuyers to realize they cannot keep bidding up the prices of homes. So just how much time is needed for this normalization to play out? We think it will be not a matter of months, but years.