Rising Rates Trigger a Flashback to 1994

 | Jun 12, 2013 | 5:00 PM EDT
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The increase in long-end Treasury yields and mortgage rates in the U.S. in the past month has been very aggressive. It's not warranted by economic fundamentals, and it's causing both commercial and residential mortgage lenders to again flash back to what happened in 1994, which I discussed in January in the column "Fed Is a Manager, Not a Leader."

That column provides a synopsis of what occurred in 1994 when rates shot up, so I won't discuss it again, but it's a good primer for what lenders and equity investors in the real estate space are concerned about right now.

The primary, immediate and domestic U.S. concern is that Treasury yields and mortgage, auto and consumer rates could increase from current levels at a faster rate than consumers can adjust to, causing them to stop borrowing. The secondary, longer-term and global concern is that the recent increase in U.S. Treasury yields, which is now being matched by all of the world's major economies, is signaling that central banks are losing control of interest rates.

These two issues have a synergistic, pro-cyclical relationship that validate each other.

Within the past month, mortgage rates in the U.S. have increased to their highest level in a year. Rates are now higher than they were before the Federal Reserve implemented QE3 and QE4 in September and December of 2012.

At par, the increase for a conventional conforming 30-year fixed-rate mortgage has been about 75 basis points, to 4% from about 3.25%; for a jumbo loan, the move has been closer to about 100 basis points, to 4.625% from about 3.625%.

The first impact is that the refinance business, which has been one of the largest contributors to money-centers' revenue and earnings, has essentially ceased. The second impact is beginning to be felt in the new-homes market, where buyers may have to wait six to 12 months to take delivery.

The fact that rates at these levels are still at near-record lows is of little concern to buyers who must guess where rates will be when they have to either close on their new purchase in six months or pay a 2%-3% lock-in fee now.

Homebuyers have been migrating toward the new-home market because of the lack of supply in the existing-home market. The move in rates and concerns about where they are heading are causing many potential buyers to shift back to the existing-home market, and this results in bidding wars in many areas.

This process has been unfolding all year and increasingly so as mortgage rates have risen.

When prices for houses and the debt capital required to purchase them increase quickly and simultaneously, buyers walk away. Contrary to popular opinion, this is not simply a smooth self-correcting mechanism that results in prices and debt costs reverting quickly.

In order for a secular increase in consumption to take place, coming out of a recession or from a low level, the price of durable, debt-financed, goods, especially homes, and the cost of debt to acquire them, must be stable and not increase faster than incomes; as I discussed in the column "Alarm Bells Out of the Housing Market."

When the opposite happens, potential homebuyers make decisions to leave the market for an extended period of time, a year or longer, and make life plans around their existing circumstances. They refinance the home they're in, sign a new long-term lease, arrange for children to spend the next year in the same school, etc.

Concerns about these effects resulting from the current surge in home prices and debt costs are causing the rapid correction in individual equities, indices, options and ETFs associated with real estate over the past month:

  • The Dow Jones Equity REIT Index (DJR) is off by 12% since May 21.
  • The PHLX Housing Sector Index (HGX) is off by 11% since May 17.
  • Toll Brothers (TOL) is off by 16% since May 23.
  • Lumber Liquidators Holdings (LL) is off by 8% since May 17.

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