U.S. Housing: Supply, Demand, and the Yield Curve

In light of the U.S. Treasury yield curve recently inverting, many are asking if home prices will be affected and how the housing market might look going forward. Co-Heads of U.S. Securitized Product Research Jay Bacow and Jim Egan discuss.

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Jay Bacow: Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. 

Jim Egan: And I'm Jim Egan, the other Co-Head of U.S. Securitized Products Research. 

Jay Bacow: And on this edition of the podcast, we'll be talking about the state of the mortgage and housing market, amidst an inverted yield curve. It's Tuesday, April 12th at 11 a.m. in New York. 

Jay Bacow: Now, Jim, lots of people have come on to talk about curve inversion and Thoughts on the Market. But let's talk about the impact to the mortgage and housing market. Now, the big question that everybody wants to know, whether or not they own a home or they're thinking about buying one, is what does an inverted curve mean for home prices? 

Jim Egan: When we look back at the history of, let's use the Case-Shiller home price index, we look back at that into the 80’s, it's turned negative twice over that 35-year period. Both of those times were pretty much immediately preceded by an inverted yield curve. However, there's a lot of other instances where the yield curve has inverted and home prices have climbed right on through, sometimes they've accelerated right on through. So if we're using history as our guide, we can say that an inverted yield curve is necessary but not sufficient to bring home prices down. And the logical next question that follows from that is, well, what's the common denominator? And in our view, there's a very clear answer, and that clear answer is supply. The times when home prices fell, the supply of homes was abundant. The times when home prices kept rising, we really did not have a lot of homes for sale. And when we look at the environment as we stand today, the inventory of homes for sale is at historic lows. 

Jay Bacow: OK, but that's the current inventory. What do you think about supply for the next year? 

Jim Egan: So I think there's two ways we have to think about the 12-month outlook for supply. The first is existing inventory, the second is new inventory, so building homes that come on market. Existing inventory is really driving that total number to historic lows. And we think it's just headed lower from here. One of the big reasons for that is, let's just talk about mortgage rates away from curve inversion. The significant increase we've seen in mortgage rates because of the unique construction of the mortgage market today, we think are going to bring inventories lower. And that's because an overwhelming majority of mortgage borrowers have fixed rate mortgages today, much more than in prior cycles in the past. And what that means is as rates go higher, as affordability deteriorates, which is something we've discussed in previous episodes of this podcast, that's for first time homebuyers. The current homeowner locked into those low fixed rates is not experiencing affordability pressure as mortgage rates go higher. In fact, they're probably less likely to put their home on the market. Selling their home and buying a new home would involve taking out a mortgage that might be 150 to 200 basis points higher. That can be prohibitively expensive in some instances, and so you actually get an environment where supply gets tighter and tighter, which could be supporting home prices. Now the other side of the equation is new homes. If existing inventory is at all-time lows, if prices continue to climb like they have, that should be an environment where we'll see more building. And we do think that inventories are already primed to come on the market over the next year because of the fact that look, we look at building permits, we look at housing starts, we look at completions, those numbers get talked about all the time when they come out monthly and they've been climbing. But they haven't been climbing all that much relative to history. What is up is kind of the interim points between those events, between housing start and completion. Units under construction is back to where we were in kind of late 2004, early 2005. Further up the chain units that have been permitted or authorized but haven't been started yet, that's starting to swell too. Now what’s currently in the pipeline isn't enough to alleviate the tight supply situation we find ourselves in. But it is enough to soften home price growth a little bit. But the real common denominator for home price growth in a curve inverted environment is that existing inventory number, which is at historic lows and continuing to go lower. 

Jay Bacow: All right, Jim. So mortgage rates are a lot higher, causing people to be locked in to their mortgage, and supply is low and you're saying probably going to stay that way. So what does that mean for housing activity going forward? 

Jim Egan: We think sales are going to fall. Housing sales normally fall either while the curve is inverted or shortly after the curve inverts, this time is no different. When we look at the impact that the incredible decrease in affordability that we've seen over the past 6 months, over the past 12 months, that also normally leads to sales volume slowing 6 months forward and 12 months forward. We've already started to see it. Existing home sales are starting to turn negative on a year over year basis, pending home sales are negative, purchase applications have decoupled even more than those statistics. So the ingredients for that decline in sales volumes that typically follow a curve inversion, they're already in place. We think that existing home sales have already peaked for at least the next year. But Jay, if we think existing home sales are going to fall, then that would mean fewer mortgages and fewer mortgages would mean less supply for mortgage-backed securities. Now that would be a good thing, right? 

Jay Bacow: Yeah, look, it's not advanced research to say that less supply is good for a market, and we think that's absolutely the case here. But the other side of the supply is demand, and the biggest source of demand, the largest holder of mortgages, is domestic banks. And domestic banks have a problem in an inverted yield curve that the incremental spread that they pick up to own mortgages versus their deposits is just going to be lower in an inverted yield curve. When we look at the data historically, we see that strong statistical correlation. That as the curve flattens, bank demand goes lower. It's also exacerbated by the fact that a lot of the mortgages that banks own are in their hold to maturity portfolios, over a trillion dollars. And those bonds yield less than where we project fed funds to be at the end of the year. So when we think about the demand for mortgages, the largest source of demand, it's going away. That's going to be a problem for mortgages. 

Jim Egan: OK, so the largest source of demand? Banks, they're going away. Who else is going to buy, if not the banks? 

Jay Bacow: Well, that's when we run into an even bigger problem. The second largest source of demand is the Fed, and the Fed has basically said in the minutes that were released last week, that they're going to be normalizing their mortgage holdings. Taking those two largest sources of demand it's likely to force money managers and overseas to end up buying mortgages, but probably at wider spreads than here. And that's why we're recommending still an underweight agency mortgages, which will cause spreads to go a little wider and maybe mortgage rates to go higher, further impacting the affordability problems that you were discussing earlier in the podcast, Jim. 

Jim Egan: All right Jay. Thanks for taking the time to talk today. 

Jay Bacow: Always great speaking with you, Jim. 

Jim Egan: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.