Markets and Economy
Mortgage rates are only one part of housing demand
The Fed plans to raise interest rates in 2022, which will reduce homebuyers’ purchasing power. But income, demographics and household wealth—not borrowing costs—are the real drivers of housing demand.
Key points
- Mortgage rates are almost certain to rise as the Fed adopts a neutral monetary stance.
- This will reduce the purchasing power of homebuyers and slow down red-hot markets.
- Still, the underlying demand for housing is driven by income, demographics and household balance sheets, both of which should remain relatively strong.
- The housing market historically does well during periods of full employment and neutral interest rates.
The Fed’s tightening will affect housing prices
Interestingly, the pandemic created favorable conditions for the housing sector—driven mainly by a plunge in 30-year mortgage rates from 4% to 3% and an increase in household incomes. Once mortgage rates tick back up, borrowers may not be eligible for the same size mortgages they’re receiving in the current market. The Federal Reserve is ending asset purchases and is expected to raise interest rates steadily over the course of this year, which could erode some homebuyers’ purchasing power.
- The Fed doesn’t directly set mortgage rates, but rates will likely rise along with bond yields as pandemic-era support is removed.
- Bidding wars may become rarer as buyers have less access to credit, meaning housing prices should cool.
The other factors at play
If a return to higher interest rates is accompanied by full employment and steady wage growth, demand for housing should remain strong.
- Fiscal relief funds during the pandemic lifted household net worth to historic highs.
- Employers responded to worker shortages by raising wages, which is boosting income growth and will cushion the impact of higher interest rates.
- Workers who went remote could finally move further from their offices to more affordable communities, no longer limited by commuting costs. In some cities, that population shift has displaced many of the workers who previously provided vital support services to nearby businesses.
- History tells us housing can keep momentum even as rates rise. In the 1990s and early 2000s, construction activity maintained a sustainable pace of about 1.5 million new homes annually, despite mortgage rates that stayed above 5%.
Hello! This is Jim Glassman, Head Economist for JPMorgan Chase Commercial Banking.
Interest rates are rising, because the economy has recovered much of the ground lost during the social- distancing lockdowns in 2020, and market participants anticipate that the Federal Reserve now can pull the support it put in place early on.
In fact, the Fed has already started that process, and this week people are expecting to hear nothing that would challenge the idea that the Fed will start to raise rates at the its next policy meeting, which comes in March.
This points to higher short-term and long-term interest rates. In fact, the 12-month- ahead futures rate, which was one-eighth of a 1/8 percent until late last year now is over 1% percent. (wWe’ve gone from pricing no rate increases in 2022 to now assuming we will see four quarter-¼ point rate increases. The 10-year Treasury yield, which has been held down by central bank asset purchases, has increased from 1.5½% last year to 1.75¾% now.
What about the assertion that we have “recovered much of the ground lost”? The proof is in the tasting of the pudding.
National output has returned to where it would have been had there been no pandemic. The unemployment rate is down to 3.9% percent and seems headed back to the 3.5%½ percent level we were at just prior to the pandemic.
Employment has recovered more slowly: Ppayrolls are still 3.5½ million shy of February 2020 levels and 5.7 million (4% percent) shy of where they likely would be in the absence of the pandemic.
But employment is well on the road to recovery. Manufacturing businesses are running at a higher operating rate than they were in February 2020. And even the eruption of bottlenecks and price pressures is proof that the demand side of the economy is back on the road.
Interest rates are probably headed higher. Even now, they are still well below pre-pandemic levels and quite a bit below levels that many assume are normal. For example, the overnight ffederal funds rate that anchors all money market rates is one-eighth of a percent,1/8% and all Fed decisionmakers believe that the appropriate federal funds rate ought to be 2--3% percent when the economy is back on its feet.
And large-scale asset purchases, which have helped to hold down long-term interest rates, are ending. Long-term interest rates reflect many factors other than the actions of central banks, of course, but if key central banks remain committed to targeting the average rate of inflation over time at 2% percent, it seems reasonable to assume that the nominal level of long-term sovereign yields ought to be higher than 2% percent, say more like 3-4% percent when the health crisis passes.
The obvious implication is that mortgage rates, which are guided by the evolution of long-term Treasury yields, are probably headed higher as well.
The Federal Reserve’s aim to shift monetary conditions to a “neutral” position shouldn’t be a threat to the economy’s ongoing expansion. Of course, some sectors, like real estate, are more sensitive to interest rates than others. So, do higher rates spell trouble for real estate activity?
Rates do matter for real estate, of course. Housing markets soared during the pandemic, aided by the plunge in 30-year mortgage rates from 4% percent to 3% percent. That decline in mortgage rates together with solid household income gains increased the amount that a typical mortgage borrower could qualify for by roughly 20% percent.
Customary terms of mortgage lending limit the size of a loan that a borrower may take on based on the share of the borrower’s income that is needed to make monthly mortgage payments. Lower mortgage rates, therefore, allow a borrower to qualify for a larger mortgage loan.
The housing sector’s good fortunes in the pandemic era are surprising only because economic upheaval and worries about the job market outlook typically outweigh the benefits of falling mortgage financing costs. But any concern about jobs and income surely were eased by the unprecedented support from the federal government.
For these reasons, it might be logical to conclude that a reversal of the pandemic-era mortgage rate decline— (we’re already back to 3.68% from 3%—) could lead to a softer trend this year. The three-quarter¾ point rise in 30-year mortgage rates since last year, with additional increases likely in the coming year, would be expected to lower the size of mortgage that a prospective homebuyer could qualify for, everything else the same.
But everything else isn’t the same.
For one, just prior to the pandemic, housing activity was gathering momentum from what seemed like a decade-long period of hibernation following the housing crisis of the late 2000’s. The housing economy’s slow recovery from the 2008-09 recession was a result of lingering problems coming out of the housing crisis and challenging job market for new college graduates and other young adults.
Young adults are the most important contributor to the rate of household formation that drives the underlying demand for housing. Household formation slowed abruptly after the 2008 housing crisis and did not return to a normal pace until about a decade ago. That’ is why, in contrast to all other economic expansions, new home construction actually detracted from real GDP growth in the most recent economic recovery.
Housing, which comprised 5% percent of GDP in the past century running up to the housing crisis, at a minimum has always carried its weight and then some during economic recoveries. But in the last decade, the share of new home construction fell to 3.5%½ percent of GDP, and its contribution to GDP growth was nil— (actually, slightly negative).
Demographic trends will remain a tail wind for housing.
Businesses have been offering more generous pay and benefit packages in an effort to address a shortage of workers. Businesses across the nation and in every industry are struggling to attract and retain workers, and that is contributing to the acceleration in worker pay visible in the surveys.
For example, the Employment Cost Index, the most comprehensive and reliable pulse of labor pay trends, indicates that hourly wages are rising twice as fast as they had been in the past decade. Bigger pay increases point to stronger income growth. Higher income levels translate into more favorable mortgage loan qualifications. As a rough approximation, a 13% percent increase in income offsets the impact of a 1 one percentage point- higher mortgage rate for a borrower’s monthly payment.
Household wealth, which has climbed to record levels in absolute terms and relative to household income, continues to support the demand for housing. If rising mortgage rates limit how much of a mortgage a borrower can obtain, households have more resources today than they did in the past to make a bigger down payment.
In addition to the lift from the acceleration in household formation, a gradual organic rebalancing has been under way that’ has been driving many workers and businesses out of pricey and congested urban markets into more affordable markets.
The response to the pandemic—the ability to work remotely, —temporarily at least— accelerated the migration to more affordable locations. This internal migration from one region to another, visible in the state employment shifts, has expanded housing needs in the areas that the population has been moving to. This explains, in part, a striking dichotomy in regional real estate trends. The population growth of the upper MMidwest and NNortheast states hasve slowed well below the nation’s average population growth, and this has been offset by above-trend population growth in the Southeast, South, and Mountain sStates.
Housing is likely to remain strong, even though it will be losing some of the supports that turbocharged activity during the pandemic era. Real estate, like many areas of the economy, has many sponsors other than interest rates, and those remain supportive.
To can find more economic analysis from our teams at jpmorgan.com/cb.
Housing demand is driven by household formation
Young adults have long been motivated to move out on their own. But that didn’t happen as often during the Great Recession, when the difficult job market dragged down housing construction between 2008 and 2012. Despite low borrowing costs and a depressed real estate market, relatively few young people were on solid enough financial footing to live independently, and the rate of new household formation stalled. Now, the opposite effect is likely in play.
- With unemployment below 4%, working young adults will create strong demand for new units, even if housing is not a bargain.
- Population flows towards the South and Mountain West will also continue to create demand for new housing stock.
- Real estate construction follows population trends, which show populations growing slowly—or shrinking—in the Midwest and Northeast states, counterbalanced by aggressive growth in the Southeast, South and Mountain West states.
What to watch
Housing prices have climbed steeply over the past two years, and they are likely to moderate to their pre-pandemic trend as interest rates rise. The total number of households should continue to climb if the labor market remains strong, creating underlying demand for new construction, which could continue to average about 1.5 million housing starts annually.
