The psychology of deflation has worked to put continued downward pressure on nationwide home prices over the past twenty-four months. The deflationary spiral works like this:
1. Consumer spending slows by choice (purchasers are “deal hunting”), or by discretion (purchasers are taking a “wait-and-see” approach), or by necessity (e.g. job cuts); then
2. Stocks are sold off as corporations anticipate falling gross revenues and lower net profits. Business spending slows and lay-offs increase in an effect to conserve capital.
3. Investors use their capital recouped in the sell-off of stocks to invest in safer asset classes such as government-backed bonds. As a result of the increased demand for bonds, mortgage interest rates move lower. This is because an increased demand from investors in bonds means those investors will be forced to accept a lower yield.
4. Lower stock prices make it more difficult for corporations to secure new debt or meet existing debt obligations (e.g. refinancing).
5. Some businesses continue to lay off workers in an effort to conserve capital and address falling revenues. Others lower prices on their goods and services in an effort to increase consumer demand.
6. The spiral starts over again at #1 as consumers are impacted by the cycle.
In an effort to address the deflationary spiral that has gripped the U.S. economy, the Federal Reserve has initiated a second round of Quantitative Easing (Q.E. 2). Pursuant to quantitative easing, the Fed purchases U.S. Treasuries and bonds in an effort to stimulate the economy by 1) creating inflation that will spur consumer spending; 2) lowering the unemployment rate by increasing consumer demand; and 3) raising the price of stocks by increasing consumer demand that results in increased revenues. You may ask why would the Fed want to create inflation – isn’t that a bad thing? The idea is that consumers would accelerate a purchasing decision in order to beat an anticipated price hike. That increase in consumer spending will lead to an increase in corporate profits which will lead to an increase in job growth which will lead to increased consumer confidence – and hopefully an end to the deflationary spiral.
What does this all mean for housing prices? Certainly putting an end to the deflationary spiral will help housing, right? Well, not so fast. Inflation is the arch nemesis of investors in bonds. Even the smell of inflation will drive investors out of bonds and into equities. When there is a lower demand for bonds, interest rates go up (meaning yields go up) in an effort to lure in bond investors with higher returns. Higher bond yields mean higher mortgage interest rates for consumers. And, as many of you know, higher mortgage interest rates mean downward pressure on home prices. A purchaser can theoretically only spend so much per month on their housing costs. When interest rates are low, it lowers their monthly payments making it easier to afford a more expensive house. However, when interest rates increase, that makes the monthly payment more expensive and usually leads to lower prices in the housing market.
Last week, there was evidence that inflation is rising in China and that the Chinese government would raise rates to fight it. Investors seeking their highest return on their investment will be more interested in Chinese bonds than the lower returns they will receive on U.S. bonds, thus raising mortgage interest rates in the U.S. And, we haven’t even begun to feel the effects of Q.E. 2 that the Fed hopes for. The inflationary spiral may have already begun.
So, if deflation leads to lower home prices and inflation leads to lower home prices, what should home purchasers be thinking? The real question is about purchasing power. Let’s assume a further 10% drop in housing prices over the next year, a $1mil property, with 25% down ($750k mortgage) and let’s look at the effect of interest rates rising 110 basis points over the same period:
1. 4.4% jumbo mortgage = $3,755 in monthly debt service
2. 5.0% = $,4,026 in monthly debt service (a 6% increase)
3. 5.5% = $4,258 in month debt service (a 13% increase)
This data demonstrates that a 6% drop in housing prices would be required to keep your monthly payments the same as they are with today’s interest rates if interest rates go up 500 basis points. If interest rates on a jumbo mortgage go up to 5.5%, then a 13% drop in home prices would be required to keep the monthly debt service at break even with today. How bearish are you?
- Why Interest Rates Keep Rising, Despite QE2 (dailyfinance.com)
- Deflation Concerns Diminish at the Fed (nytimes.com)
- Fed’s mysterious policy: How will we know if it’s working? (seattletimes.nwsource.com)