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10 June 2013
Economist Insights Moving out
The Federal Reserve has placed great importance on a recovery in the US housing market and its latest quantitative easing round directly targeted household borrowing costs. But US mortgage rates have recently spiked up, partly in reaction to speculation that the Fed would taper its QE3 bond purchases earlier than previously thought. The US housing market has been strong lately, but there is still a fear that the mortgage rate spike might dampen the recovery. Luckily the fundamentals of demand are much stronger than in the past. And as house prices are still over 25% below the pre-crisis peak, while personal income per capita is over 5% above its pre-crisis peak, it would take a significant mortgage rate increase to make housing unaffordable. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management firstname.lastname@example.org
Gianluca Moretti Fixed Income Economist UBS Global Asset Management email@example.com
In the old, simpler, days of monetary policy, central banks used to target the short-term interest rate and hope that the rest of the yield curve would affect the economy through borrowing costs. Once rates started to push against the lower bound, some central banks used quantitative easing (QE) to target the whole yield curve. The Federal Reserve went one step further by buying mortgage backed securities, directly targeting the borrowing costs for US households. Numerous speeches by Fed officials have demonstrated the importance that they place on a recovery in the housing market. After the large post-crisis correction in the residential sector, such a recovery should help put the US economy on a more robust growth path. Since the Fed is effectively targeting the mortgage rate, how will it react to the recent spike up in US mortgage rates? Arguably the Fed brought this increase in mortgage rates on itself. As soon as Chairman Bernanke mentioned the possibility of an earlier tapering of bond purchases, the US Treasury market sold off. This has knock-on effects on mortgage rates, which are generally a spread above Treasuries. Although the reasons are different, the movement is actually very similar in size and speed to the market reaction to the second round of QE in 2010 (see chart 1). Unlike QE1 and QE3, in QE2 the Fed only bought Treasuries. The economy was also weakening (which is why the Fed did more QE) and house prices had started to fall again. The combination of these factors pushed up interest rates on mortgages.
Chart 1: Exit velocities Yield on 30y US Treasuries (UST) and interest rate on 30y fixed rate mortgages (FRM), % a. From 9 August 2010 6
3 Aug Sep 2010 2010
Feb Mar 2011 2011
b. From 23 February 2013 5
Source: Bankrate.com, Bloomberg
The US economy is clearly further along in its recovery than it was in 2010 which makes exit talk more credible, but on the other hand, tapering of QE purchases would just mean a slowing in the rate of monetary easing – several steps away from tightening. When you are thinking about a 30-year bond, the question of whether tapering of QE starts a few months earlier or later should not really make a difference, but it does shift the market. Arguably, much of the recent increase in yields could be seen as a reversal of the decrease in yields that followed signals from the Fed earlier this year that the amount of QE could go up as well as down. Whatever the reasons, mortgage rates have spiked upwards and this will be felt by people who were looking to take out mortgages. The US housing market has been strong lately, posting double digit house price increases on the year, but there is still a fear that the improvement could turn out to be fragile. Luckily enough, this concern is likely to be overstated simply because the fundamentals of demand are so much stronger than in the past. One indicator of the fundamental strength of demand is the affordability index. This looks at the ability of a median income household to buy a median price home. Affordability fell during the housing boom years as people took on everlarger mortgages, but since the crash, a collapse in house prices and mortgage interest rates has sent affordability up to new highs (see chart 2). So even if people were unwilling to buy houses because they feared further price drops, and even if banks were unwilling to lend money for fear of future unemployment and capital requirements, affordability was not holding back the market. An increase in mortgage rates of half a percentage point is not going to have a huge impact on the affordability index. Such an increase is likely to push the index down slightly, but it will still remain well above the pre-bubble average. If anything is going to be pushing the affordability index, it will be rapid growth in house prices that starts to outstrip the increase in household incomes. This may make the market less affordable, but is hardly a sign for concern. It would be a sign of strength if strong affordability encourages borrowing (and the banks lend more), which would act to reduce affordability.
Chart 2: Affordable US housing affordability index (100 denotes that the median household has just enough income to afford a mortgage on the median priced home) 250 more aﬀordable 1971 1976 1981 1986 1991 1996 2001 2006 2011
200 150 100 50
Source: National Association of Realtors
The increase in yield is probably of most interest to investors in mortgage backed securities (MBS). People may take out 30-year fixed rate mortgages, but they do not tend to hold them for that long. Firstly, the average amount of time that a household stays in a home is about seven years or so, and that generally means having to take out a new mortgage. Secondly, when mortgage rates fall households tend to refinance in order to lock in the lower rates. For an MBS holder, this means that they see pre-payments of the mortgages, which effectively makes the maturity of their MBS shorter. However, as rates rise, households are not usually interested in refinancing in order to pay a higher rate, so there are fewer pre-payments. Owners of MBS then find that the expected maturity of their security will lengthen. In short, they may find that they are now effectively lending money for longer than they thought they were originally. In some cases, that will encourage MBS investors to sell some of their bonds to reduce their ‘duration risk’. If the Fed also decides to taper earlier, as some in the market expect, there could be even more upward pressure on mortgage rates. But given that house prices are still over 25% below the pre-crisis peak, while personal income per capita is over 5% above its pre-crisis peak, it would take a significant mortgage rate increase to make housing unaffordable. The housing market fell so far that it has a lot of room to run before it hits any constraints.
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