Chart of the Day – Which Matters More For the Fed – Housing Stall or Market Complacency?

by Enis September 11, 2013 1:45 pm • Commentary

Mortgage demand continues to decline.  The past 3 months have seen one of the weakest periods for mortgage application volumes during the 2009-2013 bull market.  The mortgage application data can be quite volatile week-to-week, but the overall trend over the past few months is clear:

Weekly mortgage applications change, red line drawn at 0, Courtesy of Bloomberg
Weekly mortgage applications change, red line drawn at 0, Courtesy of Bloomberg

I’ve circled in green the two extended periods when mortgage applications were consistently negative over the last 4 years.  The only other period in which mortgage applications declined as severely was in late 2010, following the expiration of the homebuyer’s tax credit.

The signs of weakness in the housing market have started to affect banks as well.  We documented that situation in the WFC CotD on Monday.  Bank of America announced further job cuts in its mortgage unit yesterday morning, providing more evidence that mortgage demand continues to deteriorate as long-end rates remain near 2 year highs.

One of the most important drivers of consumer discretionary demand in this bull market has been the significantly reduced monthly interest payments on outstanding debt.  We detailed the pivotal role low interest rates have played in this Macro Wrap post back in March.  Here was the meat:

Note that the US has never survived an instance in the last 14 years where new mortgage rates exceed existing mortgage rates without the economy tipping into a recession. And that makes sense. Without increases in real income, mortgage rates which are no longer supportive to house prices ultimately result in declining expenditures. In other words, and this is the worrying implication, without income growth there is an interest rate at which the US will tip into a recession. And that rate is declining, even as the private sector re-leverages. In 2 year’s time, that rate will probably be ~4.5% for fixed rate mortgages. If mortgage to treasury spreads stay constant at ~150bps, that would imply a 3% recessionary ceiling for 10y treasury yields.

The bold highlight at the end is THE kicker.  It’s why interest rates are so key.  Since the debt stock is still large relative to history, monthly financial obligations are even more tied to interest rate movements going forward.

The Federal Reserve is well aware of this new paradigm.  It’s why they are so wary of raising rates anytime soon.  They want consumers to enjoy the current low rate party.  But even if rates don’t go higher, the incremental juice from Fed actions is naturally declining as debt contracts keep re-setting lower.  In short, we’re all hoping that the American economy can make the transition to juice-free life better than American sports…

The recent rise in rates won’t affect most existing fixed rate mortgages (which have been more than 90% of all mortgage originations in the past few years, detailed here), but it does affect current and future housing demand.  Perhaps more importantly, a setback in the housing recovery will hurt both geographic mobility and consumer psychology, important components for economic growth and labor participation.

Federal Reserve officials are keenly aware of these relationships.  But they also sense a complacent financial market backdrop (as evidenced by San Francisco Fed head John Williams’ speech last week).  The housing recovery’s fragility vs. financial market complacency is likely the main push/pull that the sitting governors will consider at next week’s FOMC meeting.