When the coronavirus pandemic first hit in 2020, governments across the developed world stepped in to protect household incomes in ways that benefited mostly those with steady jobs and the ability to work remotely.
The hardship fell disproportionately on the low income and some manual labour workers who did not have the flexibility to work from home. High-income-earning households took the opportunity to build up savings during this period of limited spending on travel and other luxuries.
According to a Global Wealth Report by Credit Suisse, aggregate global wealth accumulated by households rose by about US$28.7 trillion in 2020 alone. Wealthier households poured money into principal home upgrades or investment properties while others channelled their savings into the stock and cryptocurrency markets.
In the US, most homes have been selling above the asking price, and offers are being accepted much quicker than before the pandemic. It became common for cash-only buyers to prevail in bidding contests, and some buyers found home inspection waivers as a powerful edge to win bids. Even outside of the US, in countries like Japan and Italy, where ageing populations have long been a deterrent for demand, price growth has also accelerated.
With ultra-loose monetary policy holding down borrowing costs, house price inflation has entered double digits in many developed economies such as South Korea, Sweden, Canada and New Zealand, with the biggest increases seen in suburbs and smaller cities, fuelled by the remote working environment as the working class sought extra home space.
Tightening interest rate policy
In response to rising inflation, central banks in Canada and the UK have embarked on meaningful policy tightening cycles. In the US, the Fed just started hiking interest rates and completed its mortgage-backed securities purchases programme which implies a wind down of the direct support to the mortgage rates market.
The US 30-year fixed mortgage rate has risen by over 75 basis points this year, breaking above the 4% level. Even at just above 4%, which is low on a historical basis, the US housing market cycle has been interest-rate sensitive, particularly the rate of change in mortgage rates.
At the current rate of change, which is north of 20% in the first quarter, worries of continued rising mortgage rates are a foreboding of a slowdown in the housing market. Arguably, rising mortgage rates would hit those with limited savings the hardest. First-time buyers who have been on the sidelines of the market because of spiralling prices in the past year-and-a-half will not be spared.
Homeowners and prospective owners will have to rethink the listing price they can afford as well as the monthly mortgage payment that is comfortable to them. When mortgage rates increase, the interest portion increases, thereby reducing the allocation to the principal, unless the total mortgage monthly payments are enlarged.
Housing market slowdown
A classic déjà vu, causing concerns for the fallout of higher mortgage rates on housing, is likely drawn from the slowdown witnessed in 2018. The slowdown occurred alongside a 90 basis point rise in the US 30-year fixed mortgage rate between January and November of that year which saw the rate increasing to 4.9%.
New home sales were down more than 14% whilst existing sales declined by approximately 10% year-on-year by December 2018. The housing slowdown was one factor that forced the Fed to stop its tightening policy after December 2018. The key question from the 2018 housing episode is whether rising mortgage rates in 2022, after the coronavirus pandemic, will rein in buyers and slow down the housing market in a similar fashion.
In addressing the housing market slowdown question, it is important to zoom in closer on the 2018 housing crisis. According to Fed research, the 2018 housing slowdown was not entirely driven by higher mortgage rates. The research indicated that a coincidental reduction of the tax deductibility of property and mortgage interest expense in 2018 played a major role in slowing the housing demand.
The biggest slowdown in home sales in 2018 was also highly concentrated in the highest price ranges, a segment of the housing market which was the most affected by the tax law changes, as opposed to the mortgage-rate-sensitive lower home price ranges.
To augment the reduction of the tax deductibility of property and mortgage interest expense proposition, let’s take a look at the 2016 period housing slowdown. During this period, mortgage rates rose by over 75 basis points between July and December 2016, but new home sales eased by only 3% over the same period.
The majority of that decline occurred in the lower priced, highly interest-rate sensitive segment of the market. This suggests that only a small decline was attributed to higher mortgage rates. The 2016 miniature slowdown more accurately captures the pre-pandemic housing market’s sensitivity to mortgage rates. On the other hand, the astronomical 2018 housing slowdown was more likely incorrectly attributed solely to increases in mortgage rates.
Mortgage-rate sensitivity is changing
The pandemic has structurally altered the housing market factors which suggests that the mortgage rates tolerance may likely be higher than that witnessed in the short-lived slowdown of 2016.
Housing demand is currently not in the mortgage-rate-sensitive low-priced homes that would decline due to higher mortgage rates. Mid-to-upper income tier buyers, less affected by the pandemic’s economic uncertainties and less sensitive to mortgage rates, have been the main homebuyers since the pandemic, mostly driven by the migration from major city centres to suburbs.
A 2021 annual report published by the Joint Center for Housing Studies of Harvard showed a robust average annual growth in home buying and home improvement spending in the mid-to-upper income buyers.
Some mortgage rate analysts have argued that waiting for home prices to drop because interest rates are going up might be a losing proposition. They argue similarly that factors that have been driving up home prices since the coronavirus pandemic are mostly supply and demand, not mortgage rates.
Homebuilder inventories are low
Without a sudden increase in the supply of housing, prices are likely to keep going up, as demand is not going to diminish overnight. Historically, major housing slowdowns have been preceded by excess supply of homes. In contrast, the current housing market is facing a persistent shortage of homes, with supply-chain logjams and labour shortages severely limiting the construction of new homes.
Homebuilder inventories have been matching the all-time lows of 2020 and 2018 as demand remains very strong against limited supply of both finished houses and construction materials.
Lastly, mortgage rates have not been rising in isolation. The factors which have pushed these rates higher, for instance, inflation which will get worse because of the Russia-Ukraine commodity shock and interest rate hikes, are occurring also in the context of strong nominal income growth and vastly better-than-pre-pandemic household balance sheets, evidenced by the fact that there is over US$2.5 trillion in excess household savings in the US, boosted by fiscal transfers.
Even on an isolated basis – though it can be jarring seeing rates above 4% which is a psychological barrier after rates have hovered below 3% – rates around 4% are still low relative to the two-decade average of mortgage rates close to 5%.
A rather sanguine perspective would be perhaps that, beyond rising mortgage rates, the real risk to the sustainability of the current housing market will be affordability.
If demand continues in concentrated areas, prices will rise and homes will end up being unaffordable, pushing the market to somewhat of a breaking point. Otherwise, the housing market appears to have some legs to run in the face of rising mortgage rates.
Richard Maparura, Senior Portfolio Manager, Asset Management, Butterfield
Sources: MRB Partners, Global wealth report 2021 & Bloomberg
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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