As Treasury yields have driven mortgage rates up over the past few months, I've written a few columns relating current events to a similar rising-rate environment that unfolded in 1994. My goal is to prepare subscribers for the potential trajectory of housing and the economy over the next 12 months.
Mortgage companies are indicating that new mortgage applications are undergoing a
retrenchment that is happening even faster than it did in 1994. In total, new applications for mortgages, including refinancing and purchasing, declined by about a third from June to July, and the same will almost certainly occur from July to August.
As I've written before, the primary issue is not the cost of debt capital, which is still reasonable in the 5% range for a 30-year fixed rate mortgage; it's the rate of change in the cost of debt capital. Mortgage rates are rising faster than homebuyers who need a mortgage can adjust to, even if they have the financial capacity to do so.
If 1994 provides a reference, the housing and mortgage industries will experience a rapid reduction in activity for the rest of this year and until mortgage rates decrease again.
Aggravating the increase in debt carry costs is the rate of appreciation in home prices over the past year. The rate of appreciation in much of the western part of the country has been well above bubble trajectory, in the 20%-plus range.
The recent increases in mortgage rates and home prices are not exclusively indicative of a strengthening economy. Although there is clearly some component of rising confidence, the primary catalyst has been a failure by the Federal Reserve in its roles as monetary policy maker and bank regulator.
The rise in Treasury yields over the past year and the accelerating rate of increase are more reflective of bond traders' lack of conviction with respect to near-future monetary policy, and have little to no consideration for economic fundamentals.
The 10-year Treasury yield is now almost 50 basis points above the comparable French sovereign bond and almost 100 basis points above the German bund. Comparing just the economic activity in each of those two countries and their sovereign debt situation, the yields on U.S. debt should be nearer to the German yields, and a strong argument can be made that they should be lower.
But Treasury yields are inflated because traders fear what the Fed's near-future actions will be. This is also one of the drawbacks to the pursuit of maximum transparency in policy. When the Fed explains all the nuances of economic activity that the Fed governors and bank presidents are considering, the risk is that market participants will not receive the intended message.
On the home price side, the increase in appreciation rates is directly attributed to the banks' failure to deal with their nonperforming loans. Although Bernanke has mentioned this in past commentary, he has always downplayed it because of the size of the issue. But the Fed is the primary regulator of the banking system and should have pursued the issue with its member banks and asked the banks to submit a plan for how they would resolve the problem.
These two failures could also be causing a pro-cyclical and perhaps even harmonic distortion in the markets. The rise in rates and values is already causing home-sale transactions to slow precipitously. And this will have an immediate impact on consumer psychology and economic activity that will warrant the Fed intervening again with some level of stimulus to counteract it: QE5.
