What if interest rates remain low for a very long time?

If mortgage rates remain low, home sales will strengthen and house prices will keep going up.

fed_taper_stimulusThere is much angst among potential homebuyers about rapidly rising prices and the potential for another housing bubble. The cheerleaders in the mainstream media are keen to squelch these concerns, and they argue that affordability is so good that rising rates won’t have much impact. This is where parsing the various markets is important.

The pundits that claim we are in no danger of inflating a new housing bubble are right — in the weakest markets. Interest rates could double, and prices would still be relatively affordable in Las Vegas. That market is so undervalued that an uptick in mortgage rates won’t stop the climb in prices (new foreclosures could, but affordability won’t).

Coastal California is a different story. Thanks to the interest rate stimulus, the best markets already reached the affordability limit, and now that we hit that limit, any reduction in affordability caused by rising rates will impact the market. At first, it will merely cause sales volumes to drop, but if the rise in interest rates is large and long term, prices will slowly deflate.

What is the average interest rate?

The GSEs began keeping records on interest rates in 1971. Since then, the average mortgage interest rate has been above 8%, and even over the last 25 years, the average has been about 7%, but is 7% to 8% really a stable long-term rate? The answer depends on how far back in history you’re willing to look. Taken in the larger context, 7% to 8% interest rates look quite high.

ust via cs

As is evident in the very long term chart of interest rates above, the interest rate cycle is very long. Alan Greenspan presided over a twenty-five year period of declining interest rates. Much of the increase in value of real estate is attributable to decreasing borrowing costs over that time. Inflation was relatively tame, so Greenspan always had the luxury of lowering interest rates to increase economic activity. Those days are gone.

During the cycle of rising interest rates, central bankers raise interest rates to combat inflation and protect the value of the currency, but they are always one step behind. When Yellen finally does start raising interest rates, we will be embarking on the next multi-decade rising cycle where inflation is a constant problem, unless you believe the federal reserve will raise rates to cool an improving economy absent inflation, something that’s never happened before.


The long-term impact of interest rate rising to 7%

I’ve written extensively about the impact of interest rates on house prices. In 2013 I recounted the housing market impact of 25 years of falling mortgage interest rates. What would happen if interest rates spent the next seven years rising back to the 7% level, the current average of the last 42 years.

Below is the chart of median resale, rental parity, and fundamental value for Orange County, California, from 1988 to late 2013. Note the upward tilt of rental parity as compared to fundamental value. That’s a result of three decades of falling interest rates.


Reversion to a mean is a concept from statistics that says values return to historic norms over time. Record low mortgage rates will not last forever. Each time values get detached from the mean, they revert back over time, and when they do, house prices generally fall in line at the new equilibrium level.

The Great Housing Bubble was kicked off by the dramatic drop in interest rates in the early 00s, but once it got started, it had a life of its own.

In the collapse of any asset bubble, values tend to overshoot to the downside as everyone who overpaid is flushed out in wave after wave of capitulatory selling. We didn’t get that this time due to a myriad of policies and market manipulations from lenders, regulators, and politicians.

If the federal reserve had not lowered interest rates, and if government regulators hadn’t suspended mark-to-market accounting, and if lenders had not embarked on a can-kicking loan modification policy to dry up MLS inventory, the housing market would have crashed far lower than it did. If the overshoot to the downside from rental parity were extrapolated to fundamental value, house prices in Orange County would have dipped well below $300,000.

Forestalling the disaster by artificially lowering interest rates means a longer and more painful period of reversion to the mean ahead. The chart below is my best guess as to how this might all play out.

Interest rates must rise from about 4.5% to 7% to reach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.

But what happens if mortgage rates remain below 5% for the next 30 years? Could it happen?

Why Very Low Interest Rates May Stick Around

Neil Irwin, DEC. 14, 2015

The Federal Reserve will most likely raise interest rates this week for the first time in nearly a decade. To understand what it means — and doesn’t mean — consider a previous year in which interest rates were on the rise.

In 1920, borrowing costs soared to their highest levels since the end of the Civil War. Some people were terrified of what it was doing to the economy. Higher rates “would practically legalize usury,” a real estate trade group warned. A Democratic senator complained that “manufacturers, merchants and businessmen are entitled to stability” after a steep rise in rates. The Federal Reserve was “confronted with conditions more or less abnormal,” acknowledged a governor of the central bank, William P. G. Harding.

The interest rate that caused this anxiety? A mere 5.4 percent on the 10-year United States Treasury note — lower than the rates during the entirety of the 1980s and most of the 1990s.

long term rates

But if you look at the longer arc of history, a much different possibility emerges. Investors have often talked about the global economy since the crisis as reflecting a “new normal” of slow growth and low inflation. But, just maybe, we have really returned to the old normal.

Very low rates have often persisted for decades upon decades, pretty much whenever inflation is quiescent, as it is now. The interest rate on a 10-year Treasury note was below 4 percent every year from 1876 to 1919, then again from 1924 to 1958. The record is even clearer in Britain, where long-term rates were under 4 percent for nearly a century straight, from 1820 until the onset of World War I.

The real aberration looks like the 7.3 percent average experienced in the United States from 1970 to 2007.

“We’re returning to normal, and it’s just taken time for people to realize that,” said Bryan Taylor, chief economist of Global Financial Data, which scours old records to calculate historical financial data, including the figures cited here. “I think interest rates are going to stay low for several decades.”

I’ve made plenty of dire predictions about the problems of rising interest rates, and I’m not alone (safety of the wrong-way herd, I guess).

“Once the economy gets going, then interest rates are going to take a big leap,” said George Soros, the billionaire hedge fund manager, in a 2013 CNBC interview.

“We can expect rapidly rising prices and much, much higher interest rates over the next four or five years,” wrote the economist Arthur B. Laffer in The Wall Street Journal in 2009. In 2014, all 67 economists surveyed by Bloomberg predicted higher rates six months hence; they fell sharply instead.

What if I am wrong, and what if mortgage rates stay low for a very long time?

Then I should learn not to go against the mechanical advice in my own reports and accept that today just might be a very good time to buy a house.


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