The Fed’s quantitative easing (QE) program for adding cash into the banking system to increase lending is set to end in October 2014, according to a recent statement by the Federal Reserve (the Fed).
The Fed has been purchasing a combination of mortgage-backed securities and Treasury securities since September 2012. These purchases mark the third round of QE (QE3) cash infusion since the 2008 recession.
As QE3 comes to a close, we’re all rightly wondering how California’s real estate market will fare under the Fed’s “normalization process” for the economy.
The most immediate effect the Fed’s policies have is on mortgage rates. Most recently, the 30-year fixed-rate mortgage (FRM) rate jumped mid-2013 due to bond market uncertainty about the Fed’s plan to wind down QE and raise short-term rates to pull back excess cash. Now that QE is indeed ending, are mortgage rates expected to rise again?
It’s unlikely. The thing the bond market is most concerned about is when the Fed is expected to act to raise the short-term rate. For the real estate market, the immediate concern lies with the adjustable rate mortgage (ARM) rate since it is adjusted based on Fed movement of the short-term rate.
Today, the short-term interest rate (the Federal Funds rate) is essentially at zero (technically, it’s at 0.09% as of the Fed’s announcement). The Fed’s target rate for the short-term interest rate remains unchanged since 2009 at 0.0-0.25%.
Historically speaking, today’s short-term nominal rate is lower than ever, seen in the chart that follows. It can only go up from here — unless the Fed goes negative (a move it certainly won’t take due to outrage among austere freshwater politicians, despite the potential advantages of going negative).
The Fed has been elusive on exactly when they will act to increase the short-term rate. Earlier in 2014, the Fed’s official timeline was to keep the short-term rate low for “a considerable time” after the end of QE. When pressed on just how long that might be, Fed chair Janet Yellen gave a guess of around six months after the end of QE.
With the end of QE scheduled for next month, the Fed might begin raising short-term rates as early as April 2015.
However, the chances the Fed will actually do so sooner than late 2015 are low.
Jumping the gun on raising short-term rates would be disastrous for our fragile housing market. Home prices remain out of reach for most end users of property (owner-occupants and long-term buy-to-let investors). Once FRM rates rise again, buyer purchasing power will decrease by an equal measure. At higher mortgage rates, homebuyers are only able to qualify to borrow less principal with the same amount of gross income. Coupled with high home prices, homebuyers relying on financing (around 80% of buyer-occupants) are at a double disadvantage.
Members of the Fed are aware of these realities. The Fed acknowledges the housing recovery continues at a slow place. Further, the Fed has changed its plan to keep the short-term rate near zero from “a considerable time” to an even more vague “when economic conditions and the economic outlook warrant a less accommodative monetary policy.”
Essentially, the short-term rate is going to remain at its present level until they feel good and ready to move it up. That adjustment will first require:
- personal incomes to rise, which they are not now doing; and
- inflation to rise at the goal of 2%, which is not now present nor seen by the bond market anytime soon.
Our prediction? The Fed won’t act to raise the short-term rate until Q3 2015, maybe even Q4 2015. By that time, employment and the broader economy are expected to be on more stable footing. Shortly before this rate increases, expect to see a gradual rise in FRM rates, the start of the next 60-year rate cycle: roughly 30 years of rising rates followed by 30 years of falling rates. The last rate cycle can be seen in the chart, above.