Analysis of Housing Market Dynamics and Affordability

With cooling inflation and an expected drop for mortgage rates, will more affordable housing lead to a big spike in sales? Our Co-Heads of Securitized Product Research take stock of the US housing market. 

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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, co-head of Securitized Products Research at Morgan Stanley.

James Egan: And I'm Jim Egan, the other co-head of Securitized Products Research at Morgan Stanley.

Jay Bacow: And on this episode of the podcast, we'll discuss our outlook for mortgage rates and the housing market over the next 12 months.

It's Thursday, May 23rd, at 1pm in New York.

James Egan: Jay, I want to talk about mortgage rates. From November through January, mortgage rates decreased over 120 basis points. But then from February to May, they've given back more than half of that decline. Where are mortgage rates headed from here?

Jay Bacow: So, day to day, week to week, it's hard to have a lot of conviction, a lot of things can happen. But, over the next 12 months, we think mortgage rates are coming down. We estimate that by summer 2025, the 30-year fixed rate mortgage will be roughly 6.25 per cent.

James Egan: Alright, that is a significant amount lower than about 7 per cent where we are right now. And that's good news for affordability in the US housing market. What gets us there?

Jay Bacow: We think inflation is going to cool, and our economists are forecasting that the Fed is going to cut their policy rate by 75 basis points this year and 100 basis points next year. In fact, our economists are forecasting eight of the G10 central banks to cut rates next year.

Now, mortgage rates are 30 year fixed rate products, so they're based more on where the longer end of the treasury curve is than the front end. But our rate strategists think ten year notes are going to rally to 375 by next summer.

When you combine all of that with our expectation for secondary mortgage rates to tighten versus treasuries, that's how we end up with that forecast for the primary rate to rally.

James Egan: All right, I want to dig in there. I really like how you highlighted the secondary mortgage rates tightening versus treasuries. One thing I know that we've both gotten a lot of questions on over the course of the past year plus is how wide mortgages are trading versus treasuries right now. So, what do you think drives that tightening basis?

Jay Bacow: There’s a lot of factors -- but in end, two of them that are always going to drive things are supply and demand. One of the interesting things is that while housing activity has picked up, we're near the decade high in the percentage of homes that are bought with all cash, which means that the supply of mortgages to the market is actually not that high.

On the demand front, we think you're going to get demand from a broad spread of investors. We think there's been some money manager supported inflows into the mortgage market. We think that as the Fed cuts rates and you get the Basel III endgame resolution, domestic banks are going to come back to the market as they get more regulatory clarity.

And then also as the Fed cuts rates, that means that FX (foreign exchange) hedging costs for overseas investors will be improved and so you think Japanese life insurance companies can go back to the market and we think there's going to be continued demand from Chinese commercial banks. But, if you get all of this support, then as mortgage rates come down, that should be good news on the affordability front in the housing market, right Jim?

James Egan: Exactly. When we combine that decrease in mortgage rates with what our US economics team is saying will be about mid-single digit growth in nominal incomes, we get an improvement in affordability over the next 12 months that we've only seen a handful of times over the past 30 years.

Jay Bacow: Now this six and a quarter forecast is certainly good news versus spot rates. It's almost two per cent below the peaks we saw last year, but I don't really think it solves the lock-in effect that we've discussed on this podcast previously.

Close to 80 per cent of homeowners have a mortgage rate below 5 per cent. So, they're still out of the money versus our expectations for our mortgage rates going next year.

James Egan: Right, and we think that's a very important point. You made the point earlier about thinking about supply and demand with respect to mortgage rates versus treasuries, and we're going to talk about it here in the housing market. We have to think about affordability improvement in terms of both that supply and demand piece.

If we look back towards the start of this year, I'd say that demand increased a little bit faster, a little bit stronger than we thought. Typically, when you see sharp improvements in affordability, it doesn't always lead to immediate increases in sales volumes. However, what we saw from November to January seemed to be a little bit quicker to stir animal spirits, perhaps because of how healthy this improvement in affordability was. Home prices were still climbing. Mortgage rates weren't even coming down because the Fed was cutting; it was because of market expectations for future fed cuts in a soft landing environment. But on the supply side, while we expect for sale listing volumes to increase as rates come down, they aren't going to race higher because of that lock-in dynamic that you just described.

Jay Bacow: So, Jim, you think more people will list their homes; but what will actually happen to sales volumes? Will people buy them?

James Egan: Right. So, I think we have to delineate between existing home sales and new home sales here. Yes, we think existing listings are going to increase on the margins. New home inventory has already increased.

Historically, new homes make up about 10 to 20 per cent of the for-sale inventory on a monthly basis. Right now, they're between 30 and 35 per cent, and that's been the case for a little while. So, when we think about our forecasts for sales volumes, we're confident that new home sales will increase more than existing home sales. And that that growth in new home sales will spur single unit starts to increase more than both of them. 

Our specific spot forecasts, 10 per cent growth in new home sales, 5 per cent growth in existing home sales, with single unit starts edging out a double digit return of about 15 per cent growth. 

Jay Bacow: Do you have specific spot forecasts for home prices as well? 

James Egan: We do. As supply increases, the pace of home price growth should slow from where it is right now. It's been accelerating for the past several months, but the absolute level of supply is still pretty tight. We're at 3.8 months of supply as we're recording this podcast. Any reading below 6 is really associated with home price growth, not just today, but at least over the course of the next 6 months -- and we're well below 6 months of inventory.

Right now, home prices are growing at about 6.5 per cent. We think they're growing to slow to about 2 per cent by the end of 2024, before accelerating to 3 per cent in 2025. So, while growing inventory leads to deceleration, tight inventory keeps home price appreciation positive.

Jay Bacow: Alright so, home sale activity is going to pick up. It's going to be led by starts, which we think will be up 15 percent and more new home sales than existing home sales. There’s new home sales up 10 per cent. Home prices we now think will end the year positive; up 2 per cent in 2024 and up 3 per cent in 2025.

Jim, always a pleasure talking.

James Egan: Great speaking with you, Jay.

Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.