House prices are rising rapidly in the UK, US, Canada and much of Europe driven by increased demand for space and low mortgage rates. In some places this trend is exacerbated by a shortfall in supply due to pandemic delays on new building (German cities for example) while in many others it reflects tight planning restrictions that have been there for years (eg the UK).
In Part 2 of this blog, to be published next week, I will look at how investors should view housing investment compared to other investments. This week I want to ask whether we are in danger of another housing bust impacting the economy and financial sector and what are the implications for monetary policy? The short answers are no we are not likely to see another financial crisis but the housing boom is likely to accelerate the Fed and probably the Bank of England to a more hawkish position.
The surge in house prices is not universal: most of the old Euro crisis countries including Greece, Ireland, Italy and Spain are not seeing it (though prices are perky in Portugal), and Japan and Korea are largely avoiding it this time. But prices are up 13% in the last year in the US, 10% in the UK and 8% in Germany. And there are widespread reports of frothy behaviour with multiple bids and prices above asking. Its worth noting that different house price indices within countries vary more than usual in exactly how fast they show prices are rising. This likely reflects a changing mix in sales – single family homes are selling fast while inner city flats are stickier. Still, there is no doubt that prices are going up quickly and buyers are often frantic.
Another bust soon?
So, is the US heading for another housing bust, an event which played a huge role in the 2008 global financial crisis? US house prices adjusted for consumer price inflation are back to the 2006 highs (see chart). But incomes have risen faster than prices since 2006 of course so the house price to income ratio is not there yet – still about 10-15% shy depending on which measure of incomes. Of course, it would take only one more year like the last one to get there.
What is different this time is that we are not seeing the same amount of financial engineering. Mortgage lending is much more controlled as is securitisation. And banks have much stronger capital ratios. This makes a financial crisis unlikely even if house prices fall back at some point. A big fall in prices could however, have quite a big impact on consumer behaviour. Currently strong house prices (alongside strong stock prices) are a support for consumer spending and are another reason for expecting the economy to do well over the next year. Not only will consumers feel wealthy but high housing turnover tends to correlate with high spending on furniture and household goods.
Are US house prices likely to fall back? For the next year there seems to be plenty of momentum although if mortgage rates rise, as I expect they will, the boom is likely to tail off. At Tricio, we expect the US 10-year government bond yield to head into the 2-3% range over the next year which will push long-term mortgage rates up too. More on monetary policy below.
The 18-year housing cycle
Another reason for seeing a peak in coming years is the 18-year housing cycle. OK, it is not always exactly 18 years but there is plenty of evidence for a house price cycle of around 18 years (call it 15-20), not just in the US but around the world. The original observation of an 18-year price cycle goes back to Homer Hoyt writing in the 1930s. US prices peaked in 1990 and then again in 2006, so 16 years. We are now 15 years on from the 2006 peak which suggests the next one is not too far away. But provided there is not too much wild speculation in the late stages (next few years) and provided the financial sector does not get carried away it does not have to mean a new financial crisis. My guess is that memories of 2008 are still too tender for that to happen.
More hawkish monetary policy?
We are already hearing from Fed governors worried about froth in housing. Eric Rosengren, President of the Boston Fed sounded a warning last weekend. (Prices are very frothy in Boston and it is worth remembering that there was a significant decline in Boston prices in 1990 as well as in 2006.) One obvious policy measure is for the Fed to scale back purchases of mortgage bonds, currently running at $40bn monthly (on top of $80bn of Treasuries), part of the QE programme. Today 30-year mortgage rates are about 3.2%, up from 2.6% last year but still below the 3.5-4% range seen in 2019. Ending the Fed’s purchases of mortgage bonds might raise rates 20-30 basis points as the spread between the 10-year Treasury and 30-year mortgage rates is about that much lower than normal currently.
To push up mortgage rates by more than that would require a general rise in long yields. The Fed cannot directly control long yields of course. We saw 2 weeks ago that when the Fed unexpectedly hinted at earlier rises in Fed Funds rate, long bond yields actually declined, on the view that the Fed was going to be tougher against inflation than had earlier seemed likely. But ending purchases of Treasury bonds earlier than now anticipated could push up government yields a bit. So, if the Fed becomes concerned by the housing market it might plump for this. At the very least it gives them another reason (financial stability) for turning more hawkish. Beyond that, the Fed is more likely to turn to ‘jawboning’ or looking at ways to restrain bank lending for housing – in effect pulling on financial stability levers rather than monetary policy.
Short rates matter more in the UK
In the UK the argument for becoming more hawkish is stronger. The Bank of England is expected to turn more hawkish on rates anyway if the economic upswing continues strongly and assuming the Delta variant can be managed without new lockdowns. Frothy housing, if it continues beyond the stamp duty holiday period, gives it another reason for that. Moreover, importantly, the policy rate in the UK is much more directly connected to mortgage rates as most people in the UK finance short-term.
Finally, and thinking slightly longer term, the connection between interest rates and housing could put a limit on how much rates need to rise before they slow the economy. If short rates in the UK and long rates in the US only have to rise a little to tip housing over, this could impact the economy quickly and turn the Fed and BoE back to caution quite smartly. This is another reason for only tightening gradually in both countries when the time comes.