Financial Watch

Late autumn, early winter will end any debate concerning whether a housing bubble exists, but the extent of the bust won’t be seen until later

Over the past seven years the single constant within the financial news has been the continued appreciation of home values. In many markets along the nation’s coasts, homeowners have seen their home’s value skyrocket by 200% in the matter of just a few years. The real estate boom began in the late 1990’s as rising incomes and expanded economic opportunities granted more families the ability to purchase their own home. Despite the recession that followed, low interest rates created enough of an incentive for further housing activity that offset the negative impacts of the economic downturn. The favorable conditions that have fueled housing during the past seven years are slowly beginning to reverse. The combination of rising interest rates, over speculation, and destabilizing economic unbalances will in all likelihood cause the housing bubble to unwind disorderly.

In the suburban neighborhood 30 miles west of Washington, DC where I currently live the average middle class home is approaching $700k. A fixed thirty-year mortgage would require nearly a $3500 monthly payment assuming a down payment of 20% or $140,000. Similar examples of excessive values can be found across our nation. In Washington, DC and several other cities the cost of purchasing significantly exceeds the cost of renting. The only rational reason for the continued appreciation of housing values is the expectation for further appreciation. This is the same belief that fueled Internet stocks during the late 1990’s, but critics will argue that we have never seen a national downturn in housing values. However, we have never seen the appreciation in home values that have occurred recently.

This fall will prove to be the tipping point for the housing market. Last year the Federal Reserve began to rein in the economic expansion by increasing short-term interest rates. Through a series of interest rate hikes, short-term rates have moved from 1% to the current rate of 2.75%. The Federal Reserve is expected to continue its path of tightening at a measurable pace throughout the rest of the year. So far the tightening cycle of the Federal Reserve has only impacted short-term interest rates. The reason long-term interest rates have held steady despite the Federal Reserve’s tightening is foreign central banks are intervening in the currency markets to hold down appreciation of their currency. The surplus dollars are being diverted into U.S. government bonds. While Financial-Watch expects international money to continue to flow into the bond market, narrowing interest rate spreads will eventually push up long-term interest rates. We expect interest rates on the U.S. government ten-year bond to end the year yielding 5-5.25%. This would put 30 year fixed mortgage rates at 6.5-7%, which would be more than enough to break the red-hot housing market.