Fed Raises Interest Rates: What Does it Mean to Us?

Fed Raises Interest Rates: What Does it Mean to Us?

Federal Reserve officials came and went this past week. Before they went, they raised the target range on the federal funds rate to 1.75%-to-2.00%. The range was lifted 25 basis points (a quarter of a percentage point) above the previous range.

The increase was really a non-event. Most market watchers expected the Fed to raise the range. The Fed followed the script and raised the range for the second time (in 25-basis-point increments) this year.

Another increase is all but assured. The odds are rising that two more increases could occur before the end of the year.

The federal funds rate is an overnight lending rate for commercial banks. It’s a base rate and an important interest rate. The federal funds market, to which the federal funds rate applies, works this way.

Commercial banks maintain reserves with the Federal Reserve. Commercial banks maintain reserves to meet reserve requirements set by the Fed. The reserves serve as a base for generating loans. They also serve as a means to clear financial transactions. When checks written against a bank are presented, the bank must have the money to honor the checks.

On any particular day, some banks have a surplus of reserves, others have a deficit. A market arises for banks to lend excess reserves to banks with a deficit of reserves.

Short-term lending rates respond immediately to changes in the federal funds rate. Long-term rates respond with a lag, if they respond at all. The Fed can raise the federal funds rate and short-term interest rates can rise above long-term interest rates if long-term interest rates don’t respond. In this case, the yield curve inverts, which can signal a recession.

Long-term interest rates will respond if the Fed raises the federal funds rate to hold consumer-price inflation in check. Consumer-price inflation is a key variable in long-term interest rates.

The Fed increased its inflation outlook last week. It projects consumer-price inflation to run at 2.1% annually for 2019 and 2020. Consumer-price inflation runs hotter than 2.1% now.

The May reading of the Consumer Price Index shows inflation running at a 2.8% annualized rate. It hasn’t run this hot in six years. The good news is that the credit-market response has remained muted. The yield on the 10-year U.S. Treasury note moved a couple basis points higher.

We saw a slight increase in mortgage rates this past week. Quotes at the national level on a prime 30-year conventional loan remain ensconced between 4.625% and 4.75%. Quotes have crept closer to the 4.75% boundary.

Is this as good as it gets going forward?

All signs point to a rising-interest-rate environment. Reprieves are always possible. That said, to float on the prospect of a reprieve is more of a gamble and less of an analytical decision.

Did Warren Buffett Call a Market Top in Housing?

USG Corp., the largest maker of drywall, recently announced that it will be acquired by Germany-based Knauf for $7 billion. The acquisition was given the green light by Berkshire Hathaway, which owns 28% of USG’s outstanding shares.

Berkshire Hathaway has served as Warren Buffett’s investment vehicle for the past 50 years. Warren Buffett is the most acclaimed investor in the past 50 years. Buffett buys when others are selling. He sells when others are buying. No investor has employed the strategy to greater wealth-generating success.

Buffett scooped up his USG ownership position during the financial crisis 10 years ago in a deal that valued USG at less than $1 billion. When the Knauf acquisition closes, Buffett’s USG investment will net him around $2 billion, nearly seven times his original investment.

USG has prospered with the new-home market. Drywall is an obvious input to a new home. Buffet has the knack for buying low and selling high. More than a few commentators have connected the dots. They have publicly speculated if Buffett is selling USG near a market top in housing.

We’re more sanguine on Buffett’s sale. USG has performed only “okay” since the housing recovery. It reported $2.9 billion in annual sales in 2011. It reported $3.2 billion last year. That’s only 1.7% annualized growth. Buffett simply received an offer too good to refuse on what is really a middling business.

Berkshire Hathaway still owns $23 billion worth of Wells Fargo stock. Wells Fargo is the largest mortgage originator in the country. No Wells Fargo shares have been sold.

In other words, it’s still all good with housing.

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Higher Interest Rates for Everyone

Higher Interest Rates for Everyone

Arrivederci.
That’s all we can say to the lower mortgage rates that breezed by in May. Mortgage rates moved notably higher over the past week. The prime 30-year fixed-rate conventional loan led the brigade. It reclaimed the 4.625%-to-4.75% range it had abandoned for lower terrain last month.

We explained last week why mortgage rates had moved lower. Market participants were edgy over the crisis du jour – the prospect of Italy leaving the European Union. Market participants are prone to extrapolate: If Italy leaves, then France and Germany leave and the 20-year-old Euro-integration experiment goes kaput. Call it “catastrophization” on steroids.

Market participants are also prone to “toddlerism.” The Italy “crisis” held the market’s attention for as long as a jangling set of keys holds a toddler’s attention. It didn’t hold it for long.

Italy was a deflationary event. Bond yields fell as bond prices rose. Mortgage borrowers who locked a week ago were the beneficiaries of the deflationary event.

The tide has since turned. Market participants are now fixated on a new set of jangling keys – an inflationary event.

The European Central Bank could announce that it will end quantitative easing (QE) within the next week. The European Central Bank’s version of QE involves asset purchases that inject new money into the banking system. If QE ends, money supply growth will slow. The corollary will be rising interest rates. At least that’s what market participants anticipate. Yields on sovereign debt in Germany, Spain, and Italy all rose over the past week.

And why is the European Central Bank willing to engage rising rates? Inflation.

The European Central Bank’s QE asset purchase program is scheduled to run through September, but a rise in Eurozone consumer-price inflation (CPI) to 1.9% on an annualized rate in May has helped set the stage for the great unwind. Investors sell bonds when they anticipate rising interest rates. Bond prices fall, yields rise. That’s been the case in Europe.

Our central bank, the Federal Reserve, has already engaged rising interest rates (also due to rising inflation).

Indeed, we expect the Fed to announce another increase – 25 basis points – in the federal funds rate this Wednesday. Traders in fed funds rate futures contracts are betting a 93% chance that the rate will be increased. They’re betting there is an 84% chance of at least one more fed funds rate increase before the end of the year. They’re betting there is a 40% chance of two more increases before the end of the year.

The impetus since January has been for interest rates to rise, and they have. The impetus is for interest rates to continue to rise. With the Europeans now favoring rising interest rates, the impetus has strengthened (both here and abroad) over the past week.

We expect that we’ll see 5% rate quotes on a 30-year fixed-rate mortgage sooner than later. We wouldn’t be surprised to see them before the end of summer.

More Expensive, Easier to Get
Borrowers jumped on the mortgage-rate reprieve that occurred over the waning days of May. The Mortgage Bankers Association reported a 4% increase in purchase activity in its latest weekly survey. Given the recent spike in rates, a lesser number associated with purchase activity will likely be reported in the next survey.

A mortgage might be a little more expensive going forward. The good news is that mortgage availability continues to increase. CoreLogic recently surveyed the landscape and finds that it really is easier to qualify for a mortgage these days. The trend has been toward loosening underwriting standards for some time.

Fannie May began accepting mortgages with LTV ratios up 97% in 2014. Freddie Mac followed in 2015. The debt-to-income ration was raised to 50% last summer for loans Fannie Mae buys.

The FICO score has been the one constant. It has held at 755 on average for a conforming conventional mortgage. The average was 705 in 2001. It spiked higher and has held higher since the 2008-2009 recession. Given the strong outlook on jobs and economic growth, the FICO score could be the next variable Fannie Mae and Freddie Mac review for easing.

We expect the trend of easing underwriting standards to continue. We expect it to continue with the prudence shown since the recession.

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Why alternative mortgages are a smart choice.

Why alternative mortgages are a smart choice.

Traditionally, mortgages in the U.S. are financed by banks that also operate other lines of business, like offering deposit accounts and insurance products. But today, the American homebuyer is anything but traditional, and they are looking to lenders other than banks to fill the gap. Fortunately, financial institutions continue to create innovative mortgages that fit the diverse needs of borrowers, rather than forcing consumers to conform to rigid standards. The end result is more people with the financing to afford the home they need, rather than being shut out of homeownership entirely.

The trend away from banks and toward nontraditional lenders is a very recent development that is reshaping the financial landscape in the U.S. This can be seen in a snapshot of the top U.S. mortgage lenders by market share in 2011 compared to 2016. In 2011, 50 percent of all home financing was underwritten by the five biggest banks in the nation. Just five years later, six of the top 10 mortgage lenders by volume were considered nonbank lenders that focus on home loans almost exclusively.

Explaining the shift in the mortgage market

Why are more homebuyers choosing alternative lenders over traditional banks? Much of the shift has to do with the increasingly strict standards that banks adhere to when vetting mortgage applications. Prospective homebuyers are now expected to have stellar credit scores, high income and significant net worth already established before being approved for a traditional loan. However, this is not the financial reality for millions of Americans. It’s also not because excluded borrowers can’t afford a home – alternative mortgages are designed for self-employed individuals whose income may be inconsistent from month to month. They often work better for families that have imperfect credit for one reason or another and just need a second chance. Ultimately, these loans are well-suited to the countless prospective homeowners who lie just outside the margins of conforming mortgage options.

Innovation in the home lending sphere has not been limited to application requirements or loan terms, either. Many alternative mortgage lenders are succeeding because they simply make the process of getting a loan easier and less stressful. Traditional banks are not known for their efficiency, and the result for mortgage applicants is a long, drawn-out process of signing paperwork and enduring waiting periods. On the other hand, new mortgage lenders have taken the market by storm purely on the basis of the superior service and support they provide. That helps explain why alternative mortgage lenders have overtaken a significant portion of the U.S. home lending market in just five years, approaching almost half of all mortgages originated by volume.

Just like the process of actually purchasing a home, you have plenty of options at your disposal when it comes to choosing a mortgage. Speak to the professionals at New Penn to learn more about how innovative lending solutions can help you afford the perfect home.

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Mortgage rates dropped, and they dropped meaningfully this past week.

Mortgage rates dropped, and they dropped meaningfully this past week.

The rate range on the prime 30-year fixed-rate conventional mortgage dropped to 4.5%-to-4.625%. It had been ensconced in a range 13-basis-points higher for the past month. Borrowers got a reprieve.

We noted last week that Italy was holding interest rates in check because of the prospect it could leave the European Union. The prospect has become more palpable in recent days. Here’s the skinny on Italy:

The anti-establishment 5-Star Movement, Italy’s largest party, and the far-right League party picked EU critic Paolo Savona as their economy minister. The two parties share a common platform – both are critical of Europe’s single currency, the euro. The parties had won more than half the votes in parliamentary elections this past March. The Savona pick was subsequently vetoed. A new vote is expected in late July.

So why would an Italian election influence U.S. interest rates?

U.S. investors are nervous because the prospect of Italy (Europe’s third-largest economy) leaving the EU opens uncharted territory. Could Italy be the first domino to fall? Does it instigate the disintegration of the euro and the EU? Uncertainty has been jacked higher.

When investors are nervous and uncertain, they seek a haven. U.S. Treasury securities are favored havens. Investors bid up the price of these securities. By doing so, they bid down the yield. The 10-year U.S. Treasury note influences long-term mortgage rates. As the yield on the 10-year note goes, so go mortgage rates.

The yield on the 10-year note dropped 25 basis points. That’s a big move. It’s no surprise, then, that we saw mortgage rates drop.

Investor sentiment is fickle, though: scared today, emboldened tomorrow.

The yield on the 10-year note spiked eight basis points higher (because of investor selling) on Wednesday. This suggests investors are less worried. More investors view (rightly, in our opinion) that Italy is less likely to leave the EU than initially imagined. Not surprisingly, mortgage rates moved higher.

This, too, shall pass, as all the teeth-gnashing passed after the Brexit vote (remember Brexit?). If we focus on the long game, we still find a rising-interest-rate environment. Indeed, market watchers expect the Federal Reserve to raise the federal funds rate 25 basis points at its June 13 meeting.

Therefore, we don’t expect to see much more improvement in mortgage rates. Then again, we don’t expect them to surge immediately higher, either. It’s worth noting that the second estimate on gross domestic product (GDP) growth for the first quarter came in a little light. GDP growth was only 2.2% when annualized. It was 2.9% in the fourth-quarter of 2017.

The new lower range on mortgage rates could hold for a while longer. But why chance it? For anyone within 30 days of closing, locking would hardly be imprudent.

Home Sales Come in Cool; Home Prices Come in Hot
The latest news on home sales was nothing to write home about. Sales of both new- and existing-homes failed to meet consensus estimates in April. The reasons differ somewhat.

New-home sales failed to meet expectations because of lower builder activity. Builders are challenged by rising land, labor, and material costs. Somewhat paradoxically, supply is up. There are 300,000 new homes on the market, the highest in nine years.

Existing-home sales remain subdued for the usual reason – low inventory (particularly in the lower-priced niches). Inventory decreased 6.3% year over year in April compared to a year ago. Existing home sales are down 1.4% year over year.

Relentless price appreciation hurts both new- and existing-home sales. The Case-Shiller Home Price Index actually showed price appreciation accelerating in March. (That said, the data are skewed by a few hot markets in Northern California and the Northwest.)

We don’t expect sales growth to gain traction in the near future. Purchase mortgage activity has eased. The MBA reports that applications were down 2% week over week for the latest reported week. The latest decrease drops the year-over-year gain to 2%.

But let’s keep things in perspective: Housing and purchase mortgage activity remain elevated year over year. They’re a lot more elevated than five years ago. Still, we don’t expect to see notable gains over the next couple months.

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Mortgage rates took a breather this past week. Instead of ascending, as they have for most of 2018, they eased back a few basis points.

Mortgage rates took a breather this past week. Instead of ascending, as they have for most of 2018, they eased back a few basis points.

The range still holds, though. Quotes on prime 30-year fixed-rate conventional mortgages remain within the 4.75%-to 4.875% range at the national level. Quotes have been more “4.75%-ish” as opposed to “4.875%-ish” in recent days.

Rate quotes on the prime 30-year loan have eased because the yield on the 10-year U.S. Treasury note has eased. The yield spiked to 3.11%, but then retreated. The yield on the 10-year note hovers around 3%. We often note that as the yield on the 10-year note goes, so go rate quotes for long-term mortgages. Such has been the case once again.

The reprieve could prove temporary.

Federal Reserve officials hinted that a bit more inflation is forthcoming. They said as much in their last meeting. The minutes of the meeting reveal that “a temporary period of inflation modestly above 2% would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.”

We could debate the meaning of temporary and modestly. A year is temporary to a Galapagos tortoise; a second is temporary to a fruit fly. It’s all perspective based on experience and anticipation. The same goes for modestly. We’re sure Queen Elizabeth and Miley Cyrus offer differing perspectives on the word.

That said, we interpret the Fed’s statement to mean that we should expect more consumer-price inflation than we’ve seen in the past 10 years. Given the direction of energy and food prices, to argue to the contrary would be difficult. (BTW, energy and food prices are excluded from the “core” calculation of the Consumer Price Index.)

Consumer-price inflation influences interest rates. It’s most influential on long-term interest rates. You don’t get much longer than a 30-year mortgage. If we have modestly more inflation, we should have modestly higher mortgage rates. If the inflation is temporary, the modestly higher mortgage rates should be temporary.

For the present, we appear to have enough uncertainty to hold mortgage rates at the lower end of the current range.

Market participants have become edgier on the prospect of Italy leaving the European Union. The country is close to confirming a government that would like to break away.

Farther east, tensions are rising between Greece and Turkey. Turkish military jets have continually violated Greek air space over the past three months. Both countries are also fiscal basket cases. The easiest political solution is to divert everyone’s attention with an international conflagration.

We expect the lower rate quotes that have materialized over the past week to hold for a bit longer. We offer a caveat: We can’t offer a firm definition for a bit. We can’t say when modestly more inflation will hit.

As for the Supply Side of the Equation…

The demand side is the primary focus when talk turns to interest rates and housing. This doesn’t mean the supply side is immune to interest-rate movements.

While some industries are impervious to interest-rate movements, others appear vulnerable. Home builders fall into the latter category. Rising interest rates can crimp demand. They can also raise financing costs. Home builders tend to rely on debt financing more than others.

This is indeed the perception. Since the Fed began tightening the money supply, the worst performing S&P 500 sector has been real estate. Since January, the S&P Supercomposite Home Builder Index has flirted with bear-market territory.

The good news is that rising interest rates might take less of a financial toll than many analysts anticipate. Toll Brothers made money in the first quarter, though less than analysts had expected. CEO Douglas Yearley Jr. dismissed the role of rising interest rates, on both the supply and demand sides, telling analysts, “They [rising interest rate] have not impacted our business.” He went on to say, “So right now we’re very comfortable with our business and [see] no issues out there.” (Yearley Jr. cited soaring lumber prices for the earnings miss.)

Toll Brothers is a high-end builder, but we expect other builders to continue to hold their water, as well. Perspective is in order: Interest rates are rising, to be sure, but they’re still low compared to historical interest rates over the past 40 years.

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Fed Holds Steady on Interest Rates in May Meeting.

Fed Holds Steady on Interest Rates in May Meeting.

Steady as she goes. That’s the headline out of the most recent meeting of the Federal Reserve’s Open Market Committee, which ended earlier this month with little surprise or fanfare. The FOMC, the chief policymaking body of the Fed that holds sway over much of the global economy, elected not to raise its key interest rate, the federal funds rate. The committee also reaffirmed its expectation to continue on its previously planned course toward more incremental rate hikes for the rest of the year.

The FOMC’s decisions shape the market for debt, and thus the interest consumers pay on loans including mortgages. But since the Fed’s decision in May to hold steady was widely predicted among analysts, the meeting did not have a significant immediate impact on consumer interest rates. Freddie Mac’s weekly Primary Mortgage Market Survey even found that average mortgage interest rates dipped slightly May 3 compared to the previous week. Still, average home loan rates are at their highest point since 2014, a result of markets having priced in the Fed’s rate hikes long before they are actually announced.

For those who keep tabs on the Fed, the May FOMC meeting was business as usual and left little room for speculation. In a poll of economists conducted by CNBC, respondents overwhelmingly predicted that the next interest rate hike would come in June’s FOMC hearing. Based on recent rate increases, this would probably result in a new rate ceiling of 2 percent.

However, experts are more uncertain on how the Fed will behave in the second half of 2018. Economic forecasts released at the May FOMC meeting favor additional rate hikes in the coming months, but exactly how many is still an open question. Some members of the FOMC panel would prefer just one additional rate hike in 2018, while outside analysts tend to favor the possibility for two more rate increases.

Real estate reaction

The takeaway for anyone involved in real estate – whether as buyers, owners or agents – is essentially the same: stay the course. While the Fed’s interest rate changes do result in more expensive home loans, they are carefully planned so as to prevent a rapid uptick in inflation. At the same time, interest rates on mortgages and the Fed’s key rate overall remain low by historical standards. In theory, these relatively low but steadily rising rates should keep the economy growing at the same modest clip. Continuously low rates could risk a spike in inflation that would increase the cost of goods and services. On the flip side, needlessly high rates make it harder for people to invest in long-term growth. Therefore, this delicate balance is something the Fed hopes to maintain as long as it can.

Ultimately, the FOMC’s job is to predict the future of the economy, and even they don’t profess to be any better at it than most. Homeowners and real estate professionals can take a similar approach and focus on their own needs as they plan for the future, and take the necessary steps to achieve their personal financial goals.

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Most market pundits expected this to happen four years ago, if not earlier.

Most market pundits expected this to happen four years ago, if not earlier.

They expected interest rates to rise, and rise meaningfully with sustained momentum.

Interest rates failed to follow the script. They’ve made up for their ad lib in 2018. Interest rates have trended in one direction – up. They continue to trend up as we write.

In the past week, the 10-year U.S. Treasury note yield has risen 12 basis points. The latest increase means the yield has risen 60 basis points year to date.

As the yield on the 10-year note goes, so go the rate quotes on long-term mortgages. The standard-bearer – the prime 30-year conventional mortgage – has kept pace with the 10-year note. Rates have risen 60 basis points since the beginning of the year. Rates are at a seven-year high. The range based on the national average has risen to 4.75%-to-4.875%.

It appears unlikely that mortgage rates have finished their ascent.

Oil prices have risen relentlessly since the beginning of the year. A barrel of West Texas Intermediate Crude goes for $71 on the spot market. It’s at a three-high. A barrel of WTIC cost less than $30 a barrel only two years ago.

Not surprisingly, transportation costs are on the rise. A recent Wall Street Journal dispatch noted that senior executives at many major U.S. companies report higher transportation costs. The WSJ cited Coca-Cola, Procter & Gamble, Nestle, and Hasboro. These companies are reporting transportation-cost increases in percentages measured in the high-single digits to high-teens.

These companies will push as much of their increased costs as they can onto consumers with higher prices. So, inflation is what we’re really talking about. Consumer-price inflation is a key variable in setting interest rates, particularly on the long-end of the curve. Consumer-price inflation is on the rise.

The April Consumer Price index posted a 2.5% year-over-year increase – its hottest reading since February 2017. The New York Federal Reserve’s Underlying Inflation Gauge (which aims to capture “sustained moves in inflation from information contained in a broad set of price, real activity, and financial data”) was more telling. It rose 3.2% year-over-year in April. That’s the highest reading since July 2006.

The Federal Reserve has wanted more consumer-price inflation for the past seven years. It’s finally getting what it wants. Consumer-price inflation has accelerated this year. That said, Federal Reserve officials are sanguine on the matter.

Federal Reserve Bank of Dallas president Robert Kaplan Kaplan forecast in a recent speech: “In the medium term, I think inflationary forces are still going to be more muted . . . Most of the forces in the world are deflationary.”

For anyone who fills up the gas tank and shops at the grocery store, the deflationary forces are difficult to decipher. Just by eyeballing the joint, we see consumer prices rising.

We mentioned last week that JPMorgan Chase CEO Jamie Dimon forecasts a 4% yield on the 10-year U.S. Treasury note. That yield still has some distance to cover before it hits 4%, but it’s progressing in that direction.

Therefore, don’t be surprised to see rate quotes on the prime 30-year conventional mortgage hit 5% in the near future. Then don’t be surprised to see rate quotes progress higher from there.

Holding Steady for Now

The Home Builder Sentiment Index held at 70 in May. It has held near 70 for 2018. Home builders remain optimistic, though they’re less optimistic compared to a year ago.

Business, fortunately, is still good. Housing starts in April were at a seasonally adjusted annual rate of 1.287 million. This is 3.7% below the revised March estimate of 1.336 million, but it is 10.5% above the start rate compared to a year ago.

As for mortgage activity, business has slowed in recent weeks. No surprise that refinances trend down, but so, too, have purchases. Purchase applications were down 2% in the latest reported week. Activity is still up 4% compared to last year.

We know that some market watchers are concerned that rising interest rates spell the end of the good days for housing. We’re not one of them. Let’s keep in mind that the economy is strong, businesses are reporting record profits, employment is at a multi-year high. These are sufficient positives to suggest that more good days are forthcoming.

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