In this episode of the REconomy podcast from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss whether or not mortgage rates will rise in 2021 and provide historical perspective on how the housing market responded during previous rising mortgage rate eras.

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“The other point is that, if mortgage rates are rising, because the 10-year Treasury yield is rising, that's typically because the economy is improving. And what's the third factor in our affordability calculation? Well, it's income. And so, that usually means that we're having an improved economy and incomes will likely grow. The housing market actually usually benefits when there's an economic decline, because rates go down. Now, incomes might go down as well, but your mortgage rates will go down. But then, when the economy starts to improve, mortgage rates might go up a little bit, but chances are incomes are going up as well.” – Mark Fleming, chief economist at First American

Transcript

Odeta Kushi: Hello, and welcome back to another episode of the REconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American. And here with me is Mark Fleming, chief economist at First American

Mark Fleming: Hi, Odeta.

Odeta Kushi: Hey, and today we're taking a trip back in time to answer a pretty contemporary question. And that is, what can mortgage rate history teach us about the housing market? This question is coming up quite a bit these days, because after hitting a historic low point of 2.65% the week ending January 7, then rates increased to 2.8% the following week. I just want to mention, by the way, that the pre-Great Recession average dating all the way back to 1971, for the 30-year, fixed-rate mortgage was just over 9%. So, if you think 2.8% is high, let's take a little walk down mortgage memory lane, what do you think Mark?

Mark Fleming: Memory lane? Wait, wait a second, did you just say rates increased to 2.8%?

Odeta Kushi: A whopping 2.8.

Mark Fleming: Whopping, absolutely whopping and, you know, part of this, and we'll talk about it a little bit later has to do with the 10-year Treasury yield rising above? Say it, what percent?

Odeta Kushi: One whole percent?

Mark Fleming: This is crazy. I recall, I think it was not even a year ago, that you and I were sitting in the office, back when you could sit in an office. You know, pre pandemic era. And our jaws dropped as we watched the 10-year Treasury rate do what?

Odeta Kushi: Oh, my goodness.

Mark Fleming: Go below 1%, which was unprecedented. And, in fact, even a below 2% Treasury yield is pretty much unprecedented, except for the last few years. So 2.8% is high seems crazy. But you know what? We decided to go walk down memory lane. So, the first thing I did was pull up an old blog post. And yeah, we have a blog. If anyone would like to subscribe, come check us out. We publish a lot of our research and analysis there as well as the podcast. And this is where you can actually find out where we commit to saying something or forecasting something and prove ourselves to be wrong. So, the very first line of this post talking about rising mortgage rates back in 2018, says this: "Last week, the 30-year, fixed mortgage rate hit a seven-and-a-half year high of 4.86%." That's high. But here's the more important one. Think of this in 2018. "Most experts believe mortgage rates will continue to rise, reaching 5% in 2019." Oops, where are we today? Oh, yeah.

Odeta Kushi: You can't see me, but I am rolling my eyes.

Mark Fleming: The eye roll there? So yeah, let's take that walk down memory lane and really understand the history of mortgage rates and where we stand today Odeta.

Odeta Kushi: I think that's a great idea. And I think it's good if we start out with a discussion of what really drives mortgage rates. What causes mortgage rates to increase? Because, as you mentioned, the Treasury yield is rising right now, why is it rising? Well, partially, partially, it's because of the news of the vaccine. It's that the economic outlook has become a little bit brighter. There is talk of fiscal stimulus, there's talk of a vaccine. And then of course, there's a little bit of the threat of inflation. Mark, do you want to talk about why the threat of inflation, or the fear of higher inflation, might result in higher Treasury yields?

Mark Fleming: Well, in case you haven't noticed, we've been spending a lot of money recently at the federal level, and potentially will spend us just a skosh more maybe in the coming month or two to battle the virus. And there's a strong argument that that is the right thing to do from a fiscal perspective. But, obviously, the traditional thought is when you spend so much money, that there must be inflation down the road. I would like to point out, and this is probably a topic for another podcast, that the theories of macroeconomics and what drives inflation, that seem to suggest that lots of money being spent would increase inflation, have not come to bear in the last decade or so. And on top of that, now there are theories that suggests that possibly one can spend as much as they want and not risk inflation. I don't know about that one either. But, definitely in the short term, there is this fear of inflation in the sense that there are these market dynamic disruptions and that all of a sudden we're all going to rush back out there after getting that shot in our arms and want to go out to the restaurants and the bars and all the services that we've not been able to enjoy. And there will just not be enough supply of it because we’ve all been hunkering down. And so, in the very short run, we'll see these dynamic differences that will drive some inflation. Maybe that's partly what would drive the mortgage rate or Treasury yields up. But, I think the broader issue is the Treasury yield is up from such a low level has a lot to do with the fact that, you know, we're a safe haven for assets. All of the quantitative easing that the Fed is doing pushes down the Treasury yield, and yes, even though it's now back above 1%, it's still historically low. So those issues are maybe more present today, but present at extremely, extremely low levels compared to the history lane, we're about to walk down.

Odeta Kushi: Absolutely. And so, as we know, that 30-year, fixed rate mortgage is loosely benchmarked to that 10-year Treasury yield. And that 10-year Treasury yield is impacted by a whole host of things. Geopolitical conditions, and, you know, economic conditions and a whole range of things, including our very own Federal Reserve, by the way, which, when they institute quantitative easing, they put a lot more pressure on that 10-year Treasury yield, bringing it down and keeping it low, which is one of the reasons why the consensus forecast for the 30-year, fixed-rate mortgage in 2021 is still hovering at about 3%. Even with some of this positive economic news, that forecast is still at about 3%. So, I just wanted to put that out there before we start to get fears of how high are rates going to go? The industry is still seeing pretty low mortgage rates. And with that, let's finally take the walk down memory lane, because I think we want to start with the 1980s. And, I think we want to talk about the fact that the 30-year, fixed-rate mortgage in the 1980s hit, what was it? Above 18% at one point?

Mark Fleming: The 1980s...flashback. That's my favorite decade of music. Oh, slight digression, hold up? Yes. 1981, 18.1% for a 30-year, fixed-rate mortgage. Why? Paul Volcker and the Federal Reserve were trying to get rid of inflation that had come about in the late 70s. How do you do that? You raise interest rates. You effectively force recession and contraction in the economy, raising those rates, trying to wring inflation out. The Paul Volcker "war on inflation" with mortgage rates at 18.1%. What did they come down to? About 10% by the end of the decade, significantly lower.

Odeta Kushi: And you know, we don't have great data on home sales and prices during that time. But, we do know that people continued to buy homes, even at 18.1%. Okay, the housing market is pretty resilient. And remember, buying a home is not just a financial decision, it's also a lifestyle decision. So, home buying continued, let's move on to the 1990s.

Mark Fleming: Well, in the 90s we also had a recession, and rates were further reduced to a shockingly low rate of 7 to 9%. And I think everybody thought that that was great. Then you have the early 2000s, where the information boom and technology starts to come into play. And that also pushes rates down. Remember, we were talking a few minutes ago about what drives rate environments in general. And there's been a long 30-year tailwind of downward pressure on inflation, downward pressure on bond yields and bond rates and consequently, downward pressure on mortgage rates as well.

Odeta Kushi: And that mortgage rate hit below 6%, I believe it was in 2003. And that was quite low for that time period. I will mention there was a point in the early 90s, about 1994, when the Federal Reserve actually increased rates, because the economy again was doing quite well. And they didn't want it to get overheated. And guess what happened to sales and prices. People kept buying. All right, now the most interesting, and maybe the big exception here, housing bubble and bust?

Mark Fleming: Well, I think it's important to note that basically prior to the housing bust, so during the housing bubble, interest rates were somewhere around 6 to 7%, they would come and go around there. And we had a housing bubble with a 6 to 7% mortgage rate. We also had a lot of turnover and a lot of other things going on that caused it. And there was actually recognition by the Fed that the housing market was a little bit hot, and they actually began to increase rates to try and cool the housing market off. Well, you know, maybe they were a little too successful, because we ended up with a great financial crisis and the recession, complex story. Lots of downward pressure then put on rates and so this is 2009, just over a decade ago. I think it's safe to say we ushered in a completely new and unprecedented era of monetary policy and, consequently, mortgage rate policy.

Odeta Kushi: Right, absolutely. And then, of course, you have after the great financial crisis, we had the Fed's quantitative easing, monetary stimulus that brought down the federal funds rate quite, quite low and mortgage rates fell alongside it significantly in that period.

Mark Fleming: We've been below 5%. For over a decade now, we've been in the 3 to 4% range for most of that decade. Right now, we've experienced what by any historical standard would be measured as phenomenally low mortgage rates for the last decade, actually. And I guess it takes the pandemic to take it even lower.

Odeta Kushi: Right. I mean, in 2012, rates had fallen to about 3.5%. I think we were thinking that that was really, really great. And now here we are complaining about rates approaching 3%. I mean, that's pretty crazy. And it also happens to be timed with a demographic tailwind. Right? Millennials are kind of at the right place at the right time. They need to buy homes at a time when rates are below 3%. And that's really working to boost demand. We talked about that all the time.

Mark Fleming: Well, my own personal memory lane, when I first bought a home, I got what I thought was a great rate at 7%. And so, context is king. I think many might say, well, it's not the 2.675% that was available three weeks ago, but it's still below three. If we really sit back and think about it, you're absolutely right. This is an extremely unprecedented low rate environment, even as it rises right now into the low threes, and rates are likely to stay there, as you said, for the next couple of years because of the longer-term economic influences out there. There's no argument that this is a benefit to the housing market, in terms of house buying power for those millennial first-time home buyers.

Odeta Kushi: Right, absolutely. And just sticking to our theme of the history here, because we were approaching the most recent years, and you started the podcast by talking about 2018. Right. So, we were all kind of spooked rates were approaching 5%. You know, there was a lot of articles out there that 5% is really the threshold that's going to make millennials pull back from the market. And then, of course, we got pretty close to 5% by the end of 2018. And then rates started to fall again. And then we had the pandemic. And then, during the pandemic, assets flocked to safety in US Treasury bonds, bringing down that yield curve. The Fed said they were going to be buying $120 billion in bonds every month, putting more downward pressure on the yield. And here we are today, below 3% mortgage rates, but still afraid of rising mortgage rates.

Mark Fleming: You know, it makes me think of a concept called anchoring bias. And it plays out in a number of different ways. But maybe what's actually going on here is an anchoring bias effect that because we saw the possibility of a 2.75% interest rate that anything higher than that is no good anymore. And is consequently higher. I don't know when we did our analysis back in 2018. In that blog post, I was referring to a survey of market participants we conducted and we asked, what would really be the binding rate that would change behavior. And they all suggested somewhere around 5.5% or 5.25% for a 30-year, fixed rate mortgage. I do suspect that we have anchored ourselves now, three years later, to a lower level at the 2.75% or below 3%. And so the behavioral change level is probably not 5% anymore. Maybe it's 4%, we don't really know, but probably lower than where it was before. But, that doesn't mean the market stops entirely. It means people buy less home, it means maybe a little bit less demand. But, honestly right now a little bit less demand relative to no supply wouldn't necessarily be such a bad thing. We can stand to have a modest increase as most are expecting. I'm juggling all of a sudden because I just forecasted like we did in 2018. Well, I'll go with it, as most are expecting interest rates to only rise modestly and still stay probably below 4%. This year, even next year, as we come out of the recession driven by the pandemic.

Odeta Kushi: You mentioned a lot of good points, but I think what people are really concerned about is that increasing mortgage rates will reduce affordability. And we've talked about this a little bit on our blog, looking at markets that, since the housing market started to heat up again in the summer, we have seen some markets where affordability has declined because nominal house price appreciation has been stronger than the affordability benefits from low mortgage rates. And so, there is this dynamic at play and, Mark, exactly to your point, the market readjusts. If we start to see mortgage rates go up, we might also see nominal house price appreciation cool, or at least moderate, a little bit. So, these are the dynamics that we're really watching. The housing market does adjust.

Mark Fleming: To be clear, this is not completely consequence free. There will be participants in the market who get priced out by a modest rise, because they were just barely in the market, so to speak in the first place. And so, you know, there are people, in the economics term, on the margin, that do get priced out of the marketplace. But, as you said, this is not a static, equilibrium sort of scenario. Markets are dynamic, and they change over time. And, if you took your econ 101 class, they sort of said, here's this miraculous point where the supply line and the demand line crossed, and we draw little lines, and we talk about equilibrium. Markets are actually rarely ever in equilibrium. They're always trying to find it. And usually when they get close, they overshoot from whichever direction they're coming to it from. And so this constant dynamic push and pull, as you say, rising rates should cool off a little bit of that house price appreciation as some marginal demand falls back out of the market. And that's actually a good thing as the market tries to find or seek that equilibrium point that it's always looking for. Right, and the other point is that, if mortgage rates are rising, because the 10-year Treasury yield is rising, that's typically because the economy is improving. And what's the third factor in our affordability calculation? Well, it's income. And so, that usually means that we're having an improved economy and incomes will likely grow. The housing market actually usually benefits when there's an economic decline, because rates go down. Now, incomes might go down as well, but your mortgage rates will go down. But then, when the economy starts to improve, mortgage rates might go up a little bit, but chances are incomes are going up as well.

Mark Fleming: So, we come back full circle to where we started, mortgage rates on the rise, from a low point, well below two to another point, not even close to three, because yields are rising. And people are actually hopeful that we're going to get past this pandemic in the next few months with the vaccine and return to normal. So good economic news is driving mortgage rates up. So, it's not just a one-sided, it's bad. It's also very, very good. Because, as you said, we are hopeful for our economic futures. And that can't be bad for any part of the economy.

Odeta Kushi: And I think that's a good place to stop. I had a great time walking down mortgage rate memory lane with you, Mark.

Mark Fleming: Thanks, Odeta. I feel like I need to go and listen to my Wham! albums on vinyl right now.

Odeta Kushi: Well, I might join you. Thank you to everyone for joining us on this episode of the real economy podcast. Be sure to subscribe on Apple, Google Spotify, or your favorite podcast platform. You can also sign up for our blog at www.FirstAm.com/economics. And if you can't wait for the next episode, you can definitely follow us on Twitter @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.