Can Housing Withstand Higher Rates?

Summary

• Rising rates have sparked alarm over inflation and the possible Fed response. But so far, few have wondered how the broader economy and housing will respond.
• We believe that if the long rates rise too much, the economy will shift to a lower gear and any related inflation concerns will die down.
• We expect housing to remain robust as long as the economic recovery remains on track.

Market Implications

• History shows housing equities are the classic boom-and-bust sector. Today they are priced for perfection. Investors looking for a cyclical trade should be underweighting housing equities.

It is no secret that the allure of sub-3% mortgage rates has stoked the housing market and home prices over the past year. But with rising rates on many investors’ minds, we ask: will they derail housing?

History is both helpful and misleading. There is little question that housing has been highly vulnerable during economic downturns (Chart 1). During or around the recessions of 1979-81, 1991 and 2009, home sales dropped precipitously. That said, during the recovery period, home sales tended to ride out fluctuations in mortgage rates. From 30,000 feet, it is more the strength of the economy and underlying demographics that have driven housing activity during the recoveries.

The Housing Cycle Follows the Yield Curve

That is not to say rates are irrelevant. Historically, the economic and housing cycle has depended far more on the short end of the yield curve than the long end (Chart 2). When the Fed cut rates to fight recessions, the longer end stabilized at a level consistent with the inflation outlook and supply/demand fundamentals, and generally traded in a relatively narrow range during the recovery. Hence mortgage rates also tended to trade within a narrow range, supporting a stable housing market.

During the post-war period, most economic cycles have ended due to the Fed pushing up the Fed Funds rate, causing the yield curve to flatten and even invert. Even the mega housing boom during 2003-2007 deflated once the yield curve inverted.

Rising Long Rates May Quell Overheating and Inflation

We again face the possibility of rising rates – but now from the long end rather than the short end. The 10-year yield has backed up about 100bp since last summer, while the short-term rates are little changed – and the Fed says it has no intention of raising them any time soon.

So far, most of the discussion about rising long-term rates has centred on what it might be implying about inflation expectations and Fed policy; and implications for other markets, including equities, FX, and gold.

There has been little mention of what rising long-term rates might mean for the economic recovery – perhaps with good reason. There is no good post-war historical template against which to assess the outlook in coming quarters.

We note, first, that both the short and long ends of the yield curve were rising throughout 2018 as the Fed gradually pushed rates up. The 10-year Treasury hit 3% before the Fed started backing away to keep the recovery going. Mortgage rates touched 5% with no discernible impact on housing (but had they stayed there, it might have hurt).

If the Economy Withstands Higher Rates, So Will Housing

The takeaway is that the economy and housing can probably weather a scenario where the 10-year Treasury goes to 2-2.5%, especially if this is largely driven by either supply or inflation fears that fail to pan out. In this scenario, at some point rising rates will pressure the economy, and any fears of inflation and overheating will subside and bring rates back down. In effect, markets will do the Fed’s job for it.

If rising rates are largely due to a steady uptick in inflation, then concerns about the Fed taking action will take precedence. That could occur if unemployment falls significantly and quickly. Again, however, if the long end moves up too much the economy (and inflation) could slow without Fed action.

We expect housing not to be driving this cycle, but rather following it. As long as the recovery remains intact, the housing market will be in good shape. If mortgage rates rise, it will do more to slow the substantial rate of home price appreciation witnessed over the past year than housing activity itself.

Housing Equities Are Priced for Perfection

Our constructive view on housing fundamentals does not carry over to housing equities. Housing is a classic boom-and-bust sector. Housing equities were very strong up to mid 2006, but when housing started to falter, equities (represented by XHB and ITB ETFs) collapsed (Chart 3). They did not recover to 2006 levels until 2018 and have achieved half the price performance to date.

But if our starting point is the March 2009 market bottom, housing ETFs have outperformed the SPX (Chart 4). A closer look shows that housing equities have retained their boom-and-bust character. Someone buying at yearend 2017 or 2019 would have endured painful selloffs and ultimately performed roughly in line with the SPX over time. Likewise, buying housing equities at cyclical lows would have been a winning strategy.

Investors looking for a cyclical trading vehicle will find much to like here. Buy-and-hold investors can probably live without the cyclical volatility.

At this point in the cycle, housing equities are riding the crest of the current boom. It is difficult to see them doing much better than the broader market, and there is considerable downside if the economy slows significantly or housing price appreciation (and builder profits) softens due to rising rates.