In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi break down the housing market implications from an eventful month of March, which included ongoing inflationary pressure, bank failures and a Federal Reserve rate increase.
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“The irony of the Silicon Valley Bank collapse is that there was a ‘bank-bust benefit,’ if you will, to the housing market. Heightened market uncertainty pushed investors to buy more treasury bonds resulting in declining yields on the 10-year treasury and a decrease in mortgage rates.”
– Odeta Kushi, deputy chief economist at First American
Transcript:
Odeta Kushi: Hello and welcome to episode 61 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. Hey Mark, a lot happened in the month of March, don't you think?
Mark Fleming: Hi Odeta. Indeed, I would say so. Bank failures, rate hikes, fed projections. Oh my.
Odeta Kushi: Oh my, indeed. Today's episode, we'll recap all of those things, and then discuss if, how and why it all matters to housing.
Mark Fleming: Odeta, you do realize this is a 10-to-15 minute podcast episode, right?
Odeta Kushi: I'm up for the challenge. And we're going to stick to the high-level points, rather than the nitty-gritty details. First, since we plan to cover what went down with the bank bust, the Fed and mortgage rates in March. I think we start at the very beginning. Federal Reserve Chairman Jerome Powell gave his semi-annual monetary policy report to Congress on March 7, and in those remarks to lawmakers, he indicated that the latest economic data have come in stronger than expected, which, quote, suggests that the ultimate level of interest rates is likely to be higher than previously anticipated, end quote.
Mark Fleming: That seems to have possibly left an opening for a 50-basis point hike in March.
Odeta Kushi: That's right. And Powell was reacting to the strong inflation and labor market reports that were indicating that inflation remains stubbornly high and the labor market continues to show strength.
Mark Fleming: If you're confused by why a strong labor market would upset the Fed chair, welcome to the topsy-turvy economic world we live in these days.
Odeta Kushi: Yes, lower unemployment and wage growth are a bad thing for the inflation fight.
Mark Fleming: That's right, a 50-basis point hike would have set the fed funds target rate to a range of between 5-5.25 percent. Keep in mind that in December, most Fed officials thought they would raise the rate this year to somewhere between 5-5.5 percent and hold it there into next year.
Odeta Kushi: Right. The median terminal rate among FOMC participants was 5.1%.
Mark Fleming: Odd again, because it stayed at 5.1% at the latest March meeting and didn't Chairman Powell suggest in his remarks to Congress that you were just referencing that inflation seemed, shall we say persistently non-transitory.
Odeta Kushi: That's a bit of a spoiler alert and we'll get to that in a minute. But how did the Fed go from hinting at a potential 50-basis point hike in early March to conversations of potentially pausing rate hikes altogether to announcing a 25-basis point hike at their FOMC March meeting?
Mark Fleming: Ah, that's easy. Nothing like a good old fashioned bank run. George Bailey's Building and Loan. Anyone, anyone?
Odeta Kushi: I do know that reference, A Wonderful Life, of course, it's a classic. So the failures of Silicon Valley Bank and Signature Bank spooked markets and FOMC members alike.
Mark Fleming: Spooked me too. Memories of 2008, for those of us who've been around long enough.
Odeta Kushi: Well, yeah, this was a pretty big deal. Now there's more than enough information out there that explains what happened. But I think it would be helpful to just get a quick overview. So, Mark, if you would do the honors.
Mark Fleming: An overview of a bank run, okay, here we go. A bank, at its simplest level, takes in deposits from customers in return for interest payments. So how much you get paid on that checking or savings account, or other services. The bank then invests those deposits. This is an important part, right? The money doesn't stay in the bank, the bank invests them in loans and securities that pay a higher rate than what they're paying you. And that's how they make money.
Odeta Kushi: So you mean banks invest in treasuries, mortgage-backed securities, commercial mortgage-backed securities, etc.
Mark Fleming: Exactly. The banks keep a certain amount of cash available, that's called their reserves are their capital just to be safe, and invest the rest in all those sorts of things.
Odeta Kushi: Right, because banks have invested most of the customers deposit in loans and securities, they only have a small percentage of actual cash available.
Mark Fleming: Yes. Bailey's Building and Loan. The money isn't in the bank. It's in your neighbor's house and your neighbor's house, that sort of thing. And that's okay. Because, most of the time, the customers don't all want their deposits back at the same time.
Odeta Kushi: All right, well, that all sign sounds fine and good. So what happened with the Silicon Valley Bank run?
Mark Fleming: Well, because Silicon Valley Bank had so much of their investments in Treasury bonds and mortgage-backed securities, both of which lose value when interest rates go up -- newsflash: interest rates have gone up -- they had what are called unrealized losses, and they're less valuable than what they bought them for. Meaning that if they had to sell them to get the money back for, say, paying their depositors back, they would not get back all the money they invested.
Odeta Kushi: But pretty much every bank in the world has unrealized losses. Again, rising interest rates have cut the value of U.S. Treasuries and mortgage-backed securities that make up a large portion of many bank's assets.
Mark Fleming: Yes, in fact, hundreds of billions of dollars of unrealized losses in treasuries and mortgage-backed securities right now. But, in the case of Silicon Valley Bank, the customers started to lose confidence that their deposits were safe and withdrew them at a higher than expected rate. And so they're running out of that capital. Silicon Valley Bank was then forced to sell more investments to provide liquidity to cover those withdrawals. All due to higher interest rates, they took a loss on the sale of those securities.
Odeta Kushi: Here we go, and more loss of confidence follows suit.
Mark Fleming: Yep, more withdrawals of deposits, more fear of missing out and being the last one to the bank, and voila, a bank run. Regulators took over the bank when they became concerned that SVP lacks the liquidity to meet customer withdrawal demands.
Odeta Kushi: Thanks for that bank run overview, Mark. Now, we promised we would touch on mortgage rates and housing. Recall that the 30-year, fixed mortgage rate is loosely benchmarked to the 10-year Treasury. And the irony of the Silicon Valley Bank collapse is that there was a "bank-bust benefit," if you will, to the housing market. Heightened market uncertainty pushed investors to buy more treasury bonds resulting in declining yields on the 10-year treasury and a decrease in mortgage rates.
Mark Fleming: And there were analysts saying that the stress on the banking system may prompt the Federal Reserve to take its foot off the pedal, at least temporarily. A pause would have allowed the Fed time to assess the risks posed to the banking system. After all, it's the Fed's fast pace of rate increases that has placed stress on the banks investment assets.
Odeta Kushi: Yes, but it could also signal to markets that the Fed remains concerned about the stability of the financial sector.
Mark Fleming: Indeed a rock-and-a-hard place situation. I do not envy the fact that they had to make this decision.
Odeta Kushi: It was a really tough choice going into that March FOMC meeting. Continue to fight inflation and raise rates, or pause and see if the banking system responds favorably or depositors lose confidence. No spoiler alerts here because the decision has already been made. And I think we've mentioned it once or twice already on this podcast. But what did they end up going with?
Mark Fleming: I guess no drum roll is needed here. A 25-basis point hike and a pretty steady projection. In those projections, the median GDP came down a little bit from December, probably recognizing the damage that could be caused to the economy by the financial uncertainty. The unemployment rate expectations modestly declined. Inflation expectations increased a bit, sort of recognizing the challenges that we are having in getting inflation down. And that ever-important terminal rate stayed the same at 5.1%. The FOMC statement did change a little bit, with mention that the U.S. banking system is sound and resilient, but that recent developments are likely to result in tighter credit conditions for households and businesses. This is like a little inflation assist.
Odeta Kushi: That's right. Powell mentioned that the tightening credit conditions work in principle in the same way as rate hikes, so that justifies why they went with 25 basis points and not 50.
Mark Fleming: It also helps to explain why that median terminal rate expectation stayed the same. We started off the episode discussing how hotter-than-expected inflation and labor market data was likely to sway the Fed towards a higher terminal rate. But now the Fed is saying that they may need to take their foot off the pedal a little bit, given banking uncertainty.
Odeta Kushi: So, what does all of this mean for the housing market?
Mark Fleming: Well, first, there's the obvious credit tightening point. With banks tightening credit, it may be more difficult for borrowers to get a mortgage. Lenders might require higher credit scores, bigger down payments or more cash reserves. Let the tighter credit conditions do a little bit of work for the Fed. Zooming out a little bit, and if we use the FOMC projections as our guide...
Odeta Kushi: And that's not always the most accurate guide, we talk more about how fed projections don't have a great record in Episode 23 of the REconomy podcast.
Mark Fleming: Yeah, forecasting the economy. It's easy. But what better way to understand the Fed, then use their own projections. The terminal rate projection of 5.1% can be achieved with one more quarter-point hike. One more and done.
Odeta Kushi: So it's possible we'll get that second 25-basis point hike at their next meeting in May. But then what?
Mark Fleming: Well, Chairman Powell explicitly said, and the March FOMC projections imply, that rate cuts are not in the FOMC's baseline expectation for the year. So one and done doesn't then mean cut.
Odeta Kushi: Despite what markets may think.
Mark Fleming: That's right. There seems to be a little bit of a disconnect there. According to the Fed, once we've hit that terminal rate, we will stay at that level at least into next year.
Odeta Kushi: The implication for mortgage rates is that there might be ongoing upward pressure on rates until the summer, but a steadying in the second half of the year as the Fed takes its foot off the pedal.
Mark Fleming: Yes, though ongoing banking uncertainty complicates the picture for a bit. While the 30-year, fixed-rate mortgage typically does follow the 10-year Treasury rate, the spread between the two widens during times of financial and geopolitical uncertainty, that means that the interest rate on home mortgages is running much higher than usual relative to the interest rate on the long-term treasury bonds right now.
Odeta Kushi: That's a good point. This pattern can be observed during the Great Financial Crisis, early 2020, and following the Fed's most recent aggressive rate hikes. Since 1972, the 30-year, fixed-rate mortgage has on average remained 1.7 percentage points higher than the 10-year treasury bond. In March, that spread was 2.9 percentage points, that's as of March 23.
Mark Fleming: So, like a whole extra percent. If financial uncertainty following bank failures persists, the spread may even widen further, and it means we're likely to see more mortgage rate volatility. On the other hand, once the end of monetary tightening is in sight, and financial conditions stabilize, that spread is likely to narrow as uncertainty eases.
Odeta Kushi: So, basically, all factors point to continued mortgage rate volatility in the coming months, but the second half of the year should bring some stability.
Mark Fleming: Should being the operative word here.
Odeta Kushi: Yes, I did not have bank run on my 2023 bingo card, so we should definitely say should. Let's hope for minimal surprises for the rest of the year. All right. Well, that's all we've got for today. I told you, we would keep it short. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.
Thank you for listening, and we hope you enjoyed this episode of the REconomy podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2023 by First American Financial Corporation. All rights reserved.
This transcript has been edited for clarity.