A Quick Comment on the Fed, Bonds & Housing
The bond market, which had initially resisted the idea of a prolonged period of higher interest rates, has embraced the idea that inflation is likely to remain elevated. We have consistently stressed that transitioning from a 3% to a 2% inflation rate would be fraught with challenges. As inflation accelerates, bond investors are increasingly seeking higher yields to compensate for this risk. Additional factors exacerbating the inflation issue include surging oil prices, large unions demanding substantial wage increases, a staggering $33 trillion deficit, and a Federal Reserve engaged in selling (QT) rather than buying bonds, among other pressing concerns. Unfortunately, none of these factors bode well for lower interest rates. The Fed’s recent communication, particularly the dot plot, has pushed expectations of rate cuts further into the future. This is because the economy continues to perform better than anticipated, and some indication that inflation may have plateaued at a level that remains unacceptably high for most Americans. While the likelihood of a soft landing is slim, we recognize that anything is possible in these complex economic times.
Shifting our focus to bonds, it’s intriguing to consider why many on Wall Street seemed caught off guard by the prevailing interest rate environment. Although we acknowledge our own past misjudgments, we have consistently argued that there is a high risk of shifting toward a higher interest rate environment. Assuming inflation stabilizes at 3%, and incorporating a term premium of 1.5% to 2%, longer-dated bonds should hover around 4.50% to 5%. This appears to be the new normal, and individuals and businesses alike should base their investment and lending decisions on these assumptions. The far-reaching impacts of rising interest rates are just beginning to permeate the system. We can attest to this firsthand as prospective borrowers grapple with refinancing challenges and encounter difficulties in qualifying for new purchases.
While housing affordability remains a significant issue for many, home prices continue to remain high and are even rising in certain markets. In hindsight, the reason for this becomes apparent: nearly 15 years of ultra-low interest rate policies have left the majority of U.S. homeowners locked into mortgages below 5%. This has discouraged potential sellers from listing their homes, while higher rates have deterred would-be buyers. In an unusual twist, the forces of supply and demand are to some extent canceling each other out. This dynamic has helped sustain property values in the non-ultra-luxury segment of the market.
Still, there are signs of potential trouble ahead as home builders are starting to offer major incentives such as 2-1 buy downs on mortgages as well as lower prices, in an effort to stimulate volume. Additionally, pressure increases on the commercial and multi-family segments of the market as loans begin to adjust. In some cases, current values considerably decreased compared to just a few years ago.