Clear proof that rising interest rates kills home sales

Since the mid 1990s, mortgage interest rates and home sales moved in opposite directions. Dodd-Frank made this inverse correlation even stronger.

surpassing_expectationsIt’s clear that rising interest rates do not boost home prices. Perhaps rising wages can offset the damage, but rising mortgage rates are never desired by realtors or existing homeowners. What’s less discussed is that rising interest rates do not boost home sales either, and while homeowners aren’t as concerned about that problem, realtors really hate it.

Back in February of 2013 when mortgage rates were near record lows, I wrote that future housing markets would be very interest-rate sensitive, despite assurances to the contrary from most macro-economists.

The prevailing economic view is that the housing market would respond positively regardless of what happens with mortgage rates because house prices in the past have correlated poorly with mortgage rates. For example, during the 1970s, interest rates rose significantly, which should have caused house prices to drop, but instead California inflated a housing bubble. During the crash from the bubbles in the 1990s and the 2000s, interest rates declined, and so did prices.

However, after the housing bubble from the late 80s petered out in the mid 90s, housing markets began to show a strong inverse correlation between interest rates and sales. If interest rates went up, sales went down, and visa versa.

Federal-Funds-Rate-Home-Sales-Volume 2

Since the new mortgage rules changed the way housing markets work., the housing market today is even more sensitive to fluctuations in mortgage rates than before.

According to the theory I postulated back in early 2013 — prior to the rate surge from 3.5% to 4.5% — rising mortgage rates should cause sales volumes to fall and falling mortgage rates should cause sales volumes to rise. The restricted inventory may cause prices to go up, but the changes in affordability caused by mortgage rate fluctuations would necessarily impact sales volumes by pricing out (or pricing in) marginal buyers.

In October of 2013 after the sudden mortgage rate spike pummeled sales, I wrote about the mounting evidence of the market’s sensitivity to mortgage rates. The mechanisms used to inflate previous bubbles — using teaser rates, allowing excessive DTIs, and abandoning amortization — these were banned by the new residential mortgage rules. Lenders can’t soften the impact of interest rate fluctuations or provide “affordability” when the market reaches its friction point. This is the main reason the market changed so dramatically and so suddenly when mortgage rates surged.


The sensitivity of the housing market to changes in rates is remarkable. As the two charts above demonstrate, the inverse correlation began to take hold in the mid 1990s, and the passage of Dodd-Frank made the inverse correlation even stronger because lenders can no longer evade the underlying math.

See what home sales will look like following the interest rate increase

Carrie B. Reyes, November 23, 2015

… when the next interest rate increase occurs — read more on that here — expect ARM rates to adjust upward immediately and FRM rates to rise soon after, probably delayed by a few months for lack of inflation and plenty of global recessions to dampen the 10-year Treasury Note rate.

Home sales and the Federal Funds rate

Now that we understand how the Fed uses the Federal Funds rate to influence the broader economy and other interest rates, take a look at how the Fed rate interacts with home sales volume in California:

Federal-Funds-Rate-Home-Sales-Volume 2

In the chart above, an adverse relationship is visible between the Federal Funds rate and home sales volume.

First, look at what happened to sales volume roughly 6-12 months following the 1994 interest rate increase (though not shown on this chart, the same reaction took place when the Fed raised rates in 1984). Home sales volume decreased throughout 1995, to pick up again in 1996.

The next time home sales volume faltered was also about 6-12 months following the increase in the Federal Funds rate, which began at the tail end of 1999.

Finally, the last time the Fed increased the Federal Funds rate was in 2004. Sales volume nosedived about 12 months later, in 2005. …

The trend is undeniable, and the reasons behind it are easy to grasp. Rising rates price out marginal buyers, diminish the buyer pool, and pummel sales.

What’s next for the housing market?

The Fed has indicated the Federal Funds rate will increase to around 0.5-1% at the end of 2015. In 2016, the rate will rise to about 1%-2%. In the following year, 2%-3%. The Fed will stage it in jumps as the economic data permits, not constant monthly increases of 0.25% as in the past several recoveries. The Fed expects the Federal Funds rate will then hover around 3% for some time:


In the image above, each dot represents a FOMC member’s projection of what the Federal Funds rate will be in the coming years, and in the longer run.

If the chart above is correct, mortgage rates will be 6% to 7% by 2018. That will require a 30% increase in wages just to maintain today’s house prices in Coastal California. How likely is that?

Thus, the volatile and descending Federal Funds rate of the past three decades is behind us for the next few decades.

When a patient first rises from their hospital bed (after having been there since 2007, as our economy has been), they don’t immediately start running marathons again. They take things slowly. And that’s exactly how the Fed envisions the economy for the next few years — the Federal Funds rate will rise gradually for the time being.

It’s not uncommon for rates to rise very slowing after they hit bottom.


With a very fragile global economy and a domestic and local job market that has yet to catch up with population increases since the 2008 recession, interest rates won’t rise too quickly. Home sales volume will be stunted in the months following the initial rate increase by the Fed, but it won’t likely plunge back to 2008 levels.

Following home sales volume’s dip towards the end of 2016, home pricing will weaken within 12 months, likely in the second half of 2017. Any momentum from homebuyers returning to the market — as they are likely to do as job numbers continue to improve — will be stifled by rising mortgage rates.

The consensus opinion this year, like every year, is for rising sales and rising  prices. They will be “surprised” as their prognostication of increasing sales will be wrong.

While prices may go up, I predict that 2016 will see California sales volumes decline, even in the face of increasing employment, because rising mortgage interest rates will price out too many people. If rates don’t go up, both prices and sales may increase, but if rates do go up, sales volumes will not.


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