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We are in unchartered territory with the combination of high inflation rates, the Fed increasing interest rates, high home values, low unemployment, and a bear market, all while potentially entering recession. It is uncommon for the Fed to increase interest rates into a bear market.
So, what might be going on and what might happen? Here are some thoughts and speculations…
The Housing Market
The 90% of 53 million mortgage holders in the US have an interest rate below 5%.1 With current 30-year mortgage rates around 5.6-6%, the housing market could relatively dry up if rates increase further. Not completely, but relatively. Many people are going to stay put because they don’t want a higher mortgage rate and therefore a higher monthly payment. If someone could afford the monthly payment of a $450,000 home at a 3% interest rate, the equivalent payment at a 6% interest rate is for a $316,000 home. 2 That is a huge difference. There will be less homes for sale on the market and less buyers.
Anecdotally, I've heard that instead of around twenty offers on a given home sale, there are now around three. But those three offers are still above asking price. Maybe buyers are used to offering over and think they must do this to compete. But twenty offers over asking price is much different than three. Once those three realize there are only three of them, offers might be reduced. Furthermore, perhaps these buyers have locked in rates that expire soon and are rushing to buy. What happens once they go away?
For those that need to move, they’ll justify it by telling themselves (probably correctly) that they will refinance when rates decline. People moving cross-country for jobs, first time home buyers, downsizers and the very wealthy come to mind.
What will all this do to home values? The median sales price of an existing home in the US is up 44% over the last two years.3 We’re already seeing price cuts on homes for sale, which has not been the norm for a few years.4 Long term, perhaps this stalls the steep increases we’ve seen recently. There is still a shortage of homes for sale, though, partially due to the Great Recession’s lagging effect of a reduced number of newly built homes. It can’t keep up with new homebuyers. Demand exceeds supply. Industry experts don’t see a plunge coming, but values could come down modestly if rates continue to increase.4
Also, new homes are built less and less for first time home buyers. Builders are constructing larger homes in the suburbs, not the 2 and 3 bedrooms of yesteryear. These newly built homes price out many first time home buyers.
With institutional investors buying more and more homes (i.e. 43% of homes in Dallas County in 2021 were purchased by institutional investors), the added demand drives up home values while driving out homebuyers.5
With less home sales, there are less sales of everything else related to buying a new home: new furniture, paint, less inspections and repairs, etc. This could lead to a recession which could curb inflation, a goal of the Fed. Or it could provide a “soft landing” whereby inflation is curbed while avoiding a recession – this is the Fed’s hope. Time will tell. It’s also important to note that if home values decrease, homeowners would “feel” poorer and spend less. This too would reduce inflation, but is the Fed okay with this? To a degree, probably so.
The Stock Market
What about the stock market? The market does not perform as well during high inflation compared to low inflation, but it still can perform positively. We addressed that here. Stocks are repriced lower when interest rates rise and that is what has happened recently. The Fed is currently focused on inflation. With so many people (demand) going after so few things (supply), prices rise (inflation). To reduce inflation, people need to stop buying so much stuff. How can the Fed encourage people to buy less?
For one, it’s through increasing interest rates. Higher rates mean the cost of money is higher. Therefore, people take out less loans and spend less- and very importantly, so do businesses. It’s more expensive to get a car loan or have a credit card balance, so demand declines. People also might save more because the interest on their savings account is higher (though not by much, especially compared to credit card interest rate increases).
Ideally people and businesses will spend less with only a moderate increase in rates. But if that doesn’t happen, what will the Fed do? They will increase rates further. And knowing that stocks get repriced lower as rates increase, the stock market could crash. And what happens when someone’s portfolio value declines? They feel poorer and spend less. And again, spending less reduces inflation. The Fed’s mandate is price control and full employment, not the stock market. If given the choice between high inflation and a stock market crash, the Fed would likely choose a stock market crash, as long as it doesn’t view it as a systemic occurrence.
If the market crashes and we enter a recession and therefore high inflation is cured, what happens next? Then one might assume the Fed drops rates, which spurs economic activity and ends the recession and the stock market recovers.
Will we ever return to “normal” prices before high inflation?
As for current prices, will we ever see them go back to where they were? Likely not. Target inflation is 2% over the long term. That means that if the Fed gets its way, prices next year will be 2% higher than they are now. For prices to go back to where they were, we would need deflation – a negative inflation rate. We don’t want deflation, as deflation can spiral out of control, just like inflation can. Therefore, get used to these prices. They’re here to stay.
(Why is deflation so bad? When people expect prices to be lower in the future, they spend less today because they think they can get a better price if they hold off. If you expect the price of a car to be lower next week, you are going to wait to buy it next week, not today. Because less people buy an item today, the price of that item declines, and this increases recession risk overall. Deflation begets deflation. Likewise, inflation begets inflation. If you expect the price of a car to be more expensive next week, then you are likely to buy the car today. And more people buying today makes prices increase, therefore contributing to inflation.6)
Oil
So, these prices are here to stay… unless of course the story around energy causing current inflation is true. The price of oil contributes to the price of everything. The pizza I ordered the other day has ingredients that had to be shipped from the manufacturer to the distributor and from the distributor to the pizza shop. And from the pizza shop to my house since it was delivered. The manufacturer also had to ship in the ingredients from somewhere. If oil prices increase, then the price of goods will increase. And, if oil prices drop, then prices of goods should drop, too, theoretically.
If this is the case, then perhaps the Fed is acting too late or using the wrong tool with interest rates. If we could get the price of oil under control (drill baby, drill… or frack baby, frack… or end the war in Ukraine and befriend Saudi Arabia), then we could get inflation under control. And by raising rates, the Fed might be doing the wrong thing at the wrong time by driving us into an unnecessary recession if oil is the main culprit of inflation.
Look around, do you still see a lot of economic activity in your hometown? I do. High gas prices aren’t noticeably reducing traffic. I still see a lot of cranes around town. And homes are still selling quickly. But the lagging effects have yet to be seen.
The Bond Market
And what about bonds? Bonds are supposed to be the ballast in a portfolio when equity prices decrease. This has not happened. Because interest rates are rising, bond prices have declined in a dramatic way. So, what should you do? The consensus is to hold, and not to panic and sell. The reason being is that rising bond yields will allow for more income from bond funds in a few years7. Also, if/when the Fed cuts rates, bond prices should reverse.
The important question is not what will happen, but what to do. How can I weather the storm and take advantage of a time like right now? Hopefully your investment strategy and financial plan can address this. Feel free to reach out to discuss.
One idea is tax-loss harvesting discussed here.
To learn about surprise fed announcements, read here.
And to read about the upcoming midterm elections and the market, read here.
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Sources
1 https://www.modbee.com/money/rising-mortgage-rates-housing-shortage/
2 https://twitter.com/aliwolfecon/status/1536852397967872001?s=21&t=K7hLZTf2sS2QEdy0rMBqSQ
3 https://twitter.com/charliebilello/status/1539281645714407424?s=21&t=K7hLZTf2sS2QEdy0rMBqSQ
6 https://www.cbsnews.com/news/explainer-why-is-deflation-so-harmful/
7 https://www.nytimes.com/2022/04/01/business/bond-market-decline.html