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Jim Scott
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Nothing to Fear

Last month the chairman of the Federal Reserve Board sent a unsettling but not unexpected message to the financial markets. Mr. Bernanke stated that continuing the Fed’s program of providing cheap and easy long-term cash to the credit markets, known as Quantitative Easing, is going to be subject to review and possible modification at the end of the year. This should not come as a surprise to the Wall Street Journal crowd even though everyone bolted for the exits. QE was a temporary emergency measure designed largely to bolster home equities and therefore save banks and must be judged a success, at least in the short run. The Chair must have concluded the housing market has improved to the point that he could think about reducing the monthly subsidies to your house payment.  

Ending QE will impact residential real estate demand. Less than two months ago the yield on ten year treasuries was 1.6 to 1.7 percent. (The fixed-rate mortgage market uses this benchmark bond to set rates, albeit with some lag time.) As of this writing, the sell-off in the bond market was such that this key rate went over 2.6 percent, meaning home loans will soon be repriced. Affordability constraints will diminish demand for real estate over the summer and fall unless people’s incomes take an unexpected turn upward, but I would not expect that to happen.

There is always the possibility June’s bond rout was an emotional response to Mr. Bernanke’s acknowledgment that QE’s days were numbered. Perhaps bond prices will rebound and yields will reverse their current course, but I doubt it. While there may be some small readjustment in the short term, the truth is higher mortgage rates are likely here to stay. Two questions remain: how much higher will the price of money go and how will an increase affect housing prices?

Because twenty percent of the nation’s homes still have negative equity, housing is not going to be thrown under the bus. The Fed will have little choice but to keep some downward pressure on loan rates in order to continue to rebuild national home equity. Mortgages will be more costly, but will remain significantly below historical norms. The market in 2014 will be much less robust than we witnessed this past spring and it will feature a better balance between supply and demand. Higher rates will moderate the ability of buyers to bid up prices, but not so much as to choke off the nascent recovery of the housing market. Mr. Bernanke needs to keep loans cheap to maintain enough demand to keep slight upward pressure on prices. He needs to chip away at that twenty percent.

Mr. Bernanke must remain focused on housing, the spring rally notwithstanding. There is a sense the wolf is at the door as I think the Great Recession is not completely finished. Home equities must increase another fifteen to twenty percent before housing can be free of the threat of deflation. In addition, the global economy is mired in a series of rolling miseries—from China to Spain—and Main Street cannot escape the long reach of globalism. I remain concerned about the medium-term health of Europe and we should hope the Germans stay in the game. China’s system of state capitalism will hold that economy together and Japan will fare better now because they have experienced the fruits of excess austerity and are in the midst of meaningful economic change.

The most immediate effect of the June Swoon has been to stock portfolios and expensive homes for sale. Those buying $300,000 condos usually do not have substantial holdings in the financial markets and have not been impacted by recent Dow losses. The stock market will probably stabilize over the summer and consumers will adjust to paying an additional interest point for loans. If national price appreciation and new home sales begin to falter later in the summer, I believe Mr. Bernanke will forget about tapering off bond purchases. He will have no other choice as he will be loathe to lose the national home equity gain that has been paid for earlier by QE. That money has been spent and it makes no sense to allow real estate deflation to become the new norm. So no matter the noise on Wall Street, historically low mortgage rates will be around for several years, making real estate a good bet.   

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