More Cooling Is Likely Due to Lingering Impact of Higher Interest Rates
Don’t be surprised by weak sales and home price growth data in the near term.
Part of the weakness is just due to a lagged effect from the spike in mortgage rates in October and November.
Of course, mortgage rates have since fallen back under 4.5 percent after approaching 5 percent in November, so sales should pick up in the spring. However, even if rates don’t start increasing again, home sales in 2019 are expected to be less than spectacular, for reasons discussed below.
For starters, mortgage rates are still up over a half of a percent over the past year. Higher interest rates typically slow the economy via the most rate-sensitive sectors: housing, durable goods (autos, appliances), business investment and, sometimes, via lower financial asset valuations.
Another key factor is slowing economic growth. Even with the unemployment rate hovering at the lowest level ever during peacetime, analysts are forecasting less robust economic growth for the U.S. over the next year or two, citing the following:
- The softening of the housing market as poor affordability limits demand, which is particularly evident in high-cost areas such as the West Coast (see Figure 1).
Figure 1: Year-Over-Year Decline in Home Sales Is More Pronounced in California
Sources: National Association of Realtors® (NAR)/California Association of Realtors/Moody’s Analytics/Arch MI
- Weakening construction has been subtracting from GDP growth in each of the first three quarters of 2018.
- The recent appreciation of the dollar, retaliation for U.S. tariffs and a slowdown in global economic growth point to a moderation of, or even a drop in, export growth.
Economic growth forecasts keep getting trimmed back. For example, Capital Economics forecasts that GDP growth could slow to 2 percent in 2019 and just 1.3 percent in 2020. If that happens, mortgage rates may have already peaked and the Federal Reserve may be forced to cut interest rates in 2020. That would result in an economic slowdown sooner than Moody’s Analytics is forecasting: They expect 2.7 percent GDP growth in 2019, falling to just 0.9 percent in 2020 before recovering to 2.4 percent in 2021.
One reason for the projected growth slump in late 2019 and 2020 is that the federal stimulus (via lower taxes and higher spending) boosted GDP growth in 2018 by between 0.5 and 1 percent, but existing budgets will soon subtract from growth unless Congress acts. Another reason is the economic slowdown in China due to the U.S. tariffs.
History Repeating Itself?
The economy in 2019 appears to face challenges similar to those that nearly stalled economic growth during 2015 and 2016, when:
- Spending on oil exploration dropped 60 percent due to a collapse in energy prices.
- Federal Reserve tightening led to a rising dollar; this in turn hurt agriculture commodity prices and emerging markets, which resulted in lower business investment in the U.S.
U.S. financial markets in late summer of 2015 started to tank due to an international negative feedback loop – rising U.S. interest rates slowed economic growth overseas, which in turn slowed the U.S. economy. Probably the only thing that saved us from a recession was that Janet Yellen put the Federal Reserve’s rising rate plans on hold and China loosened monetary policy. This time around we have both interest rates and the value of the dollar on the rise, falling energy and commodity prices, plus a new risk factor: trade war.
While the U.S. housing market wasn’t bothered by the economic slowdown in 2015 and 2016, at least nationally (see Figure 2) that period also benefited from the continued bounce-back in home prices from their over-correction on the downside during 2007–2011. The press loves citing the misleading comparison of the cumulative home price growth over the past five years of nearly 50 percent with income growth of half that figure, but that ignores that fact that prices were too low (compared to rents and historical norms) five years ago.
Figure 2: Year-Over-Year Percentage Change in Home Prices Is Slowing
Sources: Federal Housing Finance Agency/S&P Case-Shiller/NAR/Moody’s Analytics/Arch MI SA stands for Seasonally Adjusted, NSA indicates Not Seasonally Adjusted
Trade War Leads Downside Risks
So far, the trade war hasn’t caused the overall economy to slow and most economic forecasts continue to assume things won’t get out of hand. On top of the initial $50 billion in Chinese imports subject to tariffs, an additional $200 billion in Chinese imports to the U.S. are now subject to a 10 percent higher tariff, which may increase to 25 percent if current negotiations fail. The Chinese have responded to the U.S. actions by raising tariffs on an increasing number of U.S. exports to China and by allowing the yuan to fall almost 6 percent in value against the dollar, which is hurting the competitiveness of other emerging markets.
More Housing Market Cooling Expected
Other evidence of the housing slowdown includes:
- Existing home sales in November were down 7 percent from the year before.
- Sales of new single-family homes were down 12 percent from the year before and down 22 percent in September from their recent high in November 2017.
- Home prices have not declined nationally, but their rate of increase is slowing and more home sellers are reducing asking prices.
- Home builder stocks have gotten mauled, which is understandable because their costs have gone up (due to tariffs and wage growth of over 5 percent a year in the construction sector), as sales have slowed and mortgage rates have gone up.
- Home prices fell in Seattle, Washington, (which had more construction than most cities) by 3 percent over the past few months, according to the Case-Shiller index.
In Fannie Mae’s latest survey of home purchase sentiment, only 11 percent of respondents think it is a good time to buy a home, down from 23 percent. At the same time, the proportion of survey respondents who think it is a good time to sell is also low at 36 percent. In a different survey, the Conference Board found that people view this as a bad time to buy, more because housing feels too expensive than because they can’t afford it.
So far, the data suggests movement toward a more balanced market rather than a total stalling of the market.
Housing affordability varies greatly by location. It remains favorable to home ownership in most locations but is deteriorating quickly as rates rise. The NAR’s Affordability Index is still 15 percent better than its historic average for the U.S. overall, which may explain why GSE data indicates an increasing first-time homebuyer share. Also, the home ownership rate has finally started rising again. Nevertheless, markets that have experienced the largest deterioration in affordability could see larger slowdowns than the nation as a whole.
A Soft Landing Is the Most Likely Scenario
Thankfully, a soft landing is a lot more likely than a crash since economic growth is still projected to be positive and the housing market remains underbuilt.
While we may have a “Goldilocks” economy at the moment, there are always bears lurking in the woods that could slow growth, from trade wars to stock market corrections. There could also be positive economic “shocks” as well, but they are less common. For example, Congress could agree on a large infrastructure bill (or at least not cause uncertainty, via brinkmanship, over a government shutdown) and/or the administration could cut a trade deal with China, rather than add more trade barriers. An infrastructure bill seems possible, while the trade war may worsen since our trade deficit is likely to only grow due to a strong dollar and economic weakness overseas, leading to more frustration for the administration.
- Lower home price growth is not a bad thing since it will be more sustainable. Growth well in excess of income growth (unless you are climbing out of a trough) is not sustainable in the long run. It would look a lot more like a housing bubble if prices shot up while rates were rising.
- The current slowdown in price growth (especially while interest rates are going up) is what is needed to allow some hotter markets to get back into equilibrium in a non-dramatic way.
 “The Invisible Recession of 2016,” The New York Times, Sept. 29, 2018: https://www.nytimes.com/2018/09/29/upshot/mini-recession-2016-little-known-big-impact.html
 “Metro Seattle home prices falling at fastest rate in U.S.,” The Seattle Times, Nov. 27, 2018: https://www.seattletimes.com/business/real-estate/metro-seattle-home-prices-falling-at-fastest-rate-in-u-s/
 Fannie Mae National Housing Survey, December 2018: http://www.fanniemae.com/portal/research-insights/surveys/national-housing-survey.html
 Please see the latest Urban Institute’s Monthly Housing Chartpack for an excellent source of data and analysis.