While recent monetary policy tightening in the US to counteract high inflation will likely take some heat out of the US housing market, it does not spell a crash. Its overall fundamental outlook remains sound, and prices should move marginally higher over the next 12 months.
Housing demand in the US is holding up in a market that has a still low (though slightly improved) supply of homes for sale. Support for this buying appetite is coming from a firm labour market where the unemployment rate is historically low at 3.5% and where there are more than 10 million job openings – that is almost two job possibilities for every unemployed worker.
Other supportive factors are that most borrowers have low, fixed mortgage rates and that wages and household incomes have been rising rapidly.
High home prices help slow inflation
Higher mortgage origination rates and higher house prices are making homes harder to afford. While home price appreciation (HPA) is slowing, so is overall housing market activity. Sales of both new and existing homes have come off their recent peaks and we expect sales to continue to drop.
Recent data showed pending home sales slipped in July for a second month in a row. The existing home sales supply index recently rose to three months of supply. The Mortgage Bankers Association (MBA) index – a weekly measurement of nationwide home loan applications based on a sample of about 75% of US mortgage activity – is also at its lowest in five years.
All of this is in line with expectations and comes after an unsustainable 20% year-on-year home price appreciation over the last two years.
Rising shelter costs account for a large segment of high consumer inflation. Slowing the HPA rate will be a major factor in helping to bring down inflation – indeed, it is arguably crucial if the US Federal Reserve is to slow inflation towards its 2% target.
It is thus no surprise to us that the Fed is using its monetary policy tools to adjust demand in interest-rate sensitive sectors of the economy such as housing. Indeed, the average rate on a 30-year fixed mortgage has climbed to 5.55%, according to a Freddie Mac survey. That is nearly double the rate a year ago and an important factor in the ongoing cooling of the housing market.
Borrowing environment remains healthy
The fact that home price appreciation is currently slowing in no way indicates that we will see a crash – such as in the Global Financial Crisis – in the US housing market.
The strong HPA of the last few years means that nearly all borrowers have positive home equity. The proportion of borrowers with negative equity is the lowest it has been in recent memory.
Nearly all borrowers have fixed rate loans and will not face any sticker shock as interest rates rise. The number of loans in serious delinquency is at near 20-year lows (Exhibit 1) due to the strong job market, strong consumer balance sheets, robust underwriting practices and solid income growth.
As expected, higher origination rates are impacting housing activity. We believe home price appreciation will slow but remain positive.
Outlook and positioning
The performance in July of the US mortgage-back securities (MBS) sector was one of the strongest in recent memory for both absolute and excess returns.
Valuations for MBS coming into July were low. Market sentiment turned ‘risk on’ and volatility declined throughout the month. The rally and yield curve inversion has had no impact on mortgage prepayment expectations or MBS supply. Further curve flattening helped lower coupons outperform.
Given the strong performance of the sector, we have reduced our overweight positioning to neutral.
Nominal spreads on Federal National Mortgage Association (FNMA – Fannie Mae) loans at 4.0% were 126bp in mid-July and are now 110bp with a commensurate tightening in option-adjusted spreads (OAS).
We are positive on the sector. Nominal spreads are still attractive (Exhibit 2), prepayments are stable, housing activity is slowing and investor interest remains high.
Although market volatility has cooled somewhat, it remains relatively high. We see both realised and implied volatility coming down as higher interest rates adjust supply/demand imbalances and help bring down inflation. We will look for a better entry point to re-establish an overweight position.
In our coupon stack positioning, we reduced our overweight allocation to 30-year higher coupons versus lower coupons. We remain underweight in the 15-year sector where nominal spreads on lower coupons look rich. We instead prefer 20-year lower coupons.