Is 2021’s booming housing market the real deal — or is it just putting on a show?

With California home prices up 23% over the past year as of June 2021, and jobs still down 1.3 million from the pre-recession peak as of July 2021, the contrast is telling. While some of the extraordinary price increase can be explained by a supply-and-demand imbalance, another outstanding influence on home prices — interest rates — has some wondering whether the benefits of low rates have run their course.

The President of the Federal Reserve Bank of Dallas recently aired his concern about a developing housing bubble. He believes the Fed’s long run on bond purchases may be over-fueling the worrisome home price rise, according to the New York Times.

To understand the relationship between the Fed’s bond market purchases and home prices, a closer look is necessary.

Interest rates on long-term products, such as 30-year fixed rate mortgages (FRMs), reflect bond market investor perceptions about the level of success the Fed will achieve fighting inflation. When the Fed’s inflation fight becomes aggressive, the long-term bond rates decline as investors pile back into bonds. In contrast, when the Fed allows inflation to rise beyond its target rate, investors shy away from bonds, and these bond rates rise.

In other words, when bond prices are rising, interest rates tend to fall. When bond prices fall, interest rates rise; an inverse relationship.

Beginning in March 2020, the Fed began buying mortgage-backed bonds (MBBs), thereby reducing the supply of MBBs. Axiomatically, a reduced bond supply means higher prices — and lower yields, reflected in lower interest rates.

MBB purchases are a helpful Fed tool to stimulate the economy during fragile economic times, as lower interest rates and a higher money supply encourage consumers to take out loans, and banks to lend. This includes auto loans, personal loans and, yes, mortgage loans.

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Everyone is talking about high inflation — but what about home prices?

Throughout 2020, mortgage interest rates continuously declined, hitting an all-time low in January 2021. While they have risen slightly since then, interest rates remain near historic lows.

With home prices continuing to rise rapidly and home sales volume fully recovered, the Fed’s continued MBB purchasing seems a little excessive, and even dangerous.

The coming bond taper

The Fed has broadly considered a bond taper in mid-2021, according to Brookings. In this taper, the Fed will gradually decrease its MBB purchases, slowly withdrawing their support. At the same time they are reducing MBB purchases, they will not be raising their benchmark interest rate; the Federal Funds Rate. The Fed intends to keep this rate low through at least 2023, but the extra boost of MBB purchases will be removed well before that date.

However, a resurgence in COVID-19 cases and a disappointing July 2021 jobs report have put these bond taper plans on a temporary hold. At this rate, the bond taper will likely occur in the remaining months of 2021, but it all depends on economic performance. The President of the Fed Bank of New York recently suggested the bond taper will begin when sufficient cumulative employment gains occur, regardless of the slowdown in job gains this summer. He expects to hit their employment target before 2022.

Another unknown the Fed needs to consider is the impact of the expiration of the foreclosure and eviction moratoriums. The federal foreclosure moratorium ended on July 31, 2021, and here in California, the eviction moratorium ends on September 30, 2021.

When the eviction moratorium ends, vacancies will rise. Further, as the foreclosure moratorium is now lifted, expect to see a rise in multiple listing service (MLS) inventory. This increase in forced sales will be in lieu of the foreclosure crisis that occurred during the 2008 recession — this time around, the major difference maker will be the high levels of home equity that will allow jobless homeowners unable to resume mortgage payments to simply sell their home, avoiding the loss of foreclosure.

Still, when the Fed takes their foot off the gas by drawing down bond purchases, it will be another blow on top of the slowing pace of job gains and the coming inventory surge. With too many balls in the air, the Fed might just drop them all, with the housing market bearing the consequences.

Savvy real estate professionals will watch the Fed’s steps in the coming months. Once the Fed pulls back on MBB purchases, the domino effect of higher interest rates — and lower home prices — will follow.