Several factors will likely keep US house prices on an upward trajectory this year. Still low mortgage rates as well as the post-pandemic exodus out of urban areas are sustaining demand, as do working-from-home business models, while the supply of homes for sale has dropped to less than two months’ worth. This could have consequences for US inflation and possibly monetary policy.
Home prices across the US were up by 20% year-on-year, according to the latest data (see Exhibit 1), supported by (until recently) still low mortgage rates, strong demand and low inventories of homes for sale. This has implications for inflation. Shelter, which also includes rents, makes up nearly a third of the CPI inflation basket, and 40% of core CPI. Thus even small increases in rent and home prices can have noticeable effects on overall inflation.
Source: Zillow Research; June 2022
Mortgage origination rates are about 220bp higher than they were at the 2020/2021 low. However, at around 5.20%, today’s rates are still low when compared to rates over the past 40 or 50 years.
The current high demand is stemming from pandemic-induced trends: people seeking less densely populated areas, and more generally, moving out of urban areas.
Alongside this, many businesses are adopting hybrid working models that allow workers to operate from their homes for 20% to 50% of the time and in some cases longer. Another upshot from the pandemic is that homeowners are more in need of greater space as families are staying home for work and schooling.
The overhang of underwater borrowers selling properties in distress due to the global financial crisis has long dissipated. The supply of homes for sale peaked at 12 months’ worth of supply in 2011, but more recently, supply has dipped to below two months. The number of existing homes for sale has dipped to below one million for the first time in 20 years.
Strong employment and home finances mean low mortgage deliquencies
The unemployment rate of 3.6% is at a post-pandemic and near a 50-year low. US labour force participation has been inching higher and wages have been rising at the fastest pace in many years.
Consumer balance sheets are generally in good shape and anyone who wants a job can have one. Home prices have been rising at a steady clip. As a result, very few borrowers are in a negative equity situation where the value of their mortgage exceeds the value of their house.
Borrowers’ delinquencies have trended lower and are close to pre-pandemic levels for FNMA and Freddie Mac borrowers (Exhibit 2). Delinquencies for multi-family Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) borrowers are low as the fundamentals in apartment rentals are also strong.
Source: FRED economic data; June 2022
Fundamental outlook for US residential credit is positive
Borrowers generally have jobs and are enjoying income growth and substantial home price appreciation.
A marked percentage of borrowers took advantage of the low interest rates of the last two years and locked in 30-year fixed rate financing.
New housing supply has been slow to come on line due to a difficult regulatory framework, labour shortages and supply chain issues for building materials, so there is a supply/demand imbalance in housing. We expect home prices to continue rising in 2022, although not at the 20% rate we have seen over the last two years.
Affordability is becoming a challenge for borrowers as home prices have been rising faster than incomes and mortgage rates have risen sharply this year. We believe that while this will slow the rate of home price appreciation, it will not turn down.
One other impact this is having is a ‘lock-in’ effect related to pre-payments. With the rise in interest rates, less than 2% of the outstanding mortgage universe has an economic incentive to refinance.
We think cash-out refinancing activity will be largely curtailed as borrowers will not want to give up their low rate mortgages to extract home equity. We instead foresee borrowers tapping into credit lines and leaving their primary mortgage loans intact.
It will also be harder for borrowers to move because mortgages are not portable. Moving house would mean giving up attractive low-cost financing.
As a result, we expect pre-payments to be slower than expected. Low coupon interest-only mortgage securities in particular are one way to take advantage of this ‘lock-in’ effect.
In a rising rate environment, mortgage-backed securtities (MBS) tend to outperform other fixed income asset classes due to its shorter duration and the benefits of slower prepayments and lower supply.
Unlike corporate or Treasury bonds, MBS are amortising assets with monthly cash flows. Each month, investors receive interest payments as well as scheduled and unscheduled principal repayments. These frequent, interim cash flows give MBS investors the opportunity to continuously reinvest capital as rates rise. This is a major difference from corporate or Treasury bonds.
 Note: On average, housing is 16% of headline PCE and 18% of core PCE; the PCE price index is the inflation measure most closely tracked by the US Federal Reserve; sources: Housing Prices and Inflation | The White House, data on personal consumption expenditures (PCE) by type of product
 30-year fixed mortgage rate; data as of 9 June; source: Mortgage Rates – Freddie Mac
 According to the Truly Refinanceale Index