by Brian Brady
Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL
Do you want to look into the crystal ball through the eyes of Federal Reserve Chairman, Ben Bernanke? Will that help you predict mortgage rates and housing prices for 2007? I try to outguess the Fed all the time and I’ve decided that we’ll see a significant decline in short-term interest rates by YE2007.
The answer is usually buried in paragraph three or four of government reports. The economic benchmark that is oft overlooked is the nominal GDP growth rate. The nominal GDP growth rate includes the effect of inflation. Nominal GDP growth reflects the ability of the US economy to pay our debts. The Fed Funds rate reflects the interest the economy pays on its debt. When the two are imbalanced, runaway inflation or its opposite effect, asset deflation, occurs. When nominal GDP exceeds the Fed Funds rate, we have a capital surplus which leads to inflationary pressures. When nominal GDP is less than the Fed Funds rate, asset deflation occurs. Leveraged assets, notably stocks and houses, decline.
Let’s look at recent history to understand recent Fed activity as it related to nominal GDP. In 1990, 1995, and 2001, The Fed Funds rate exceeded nominal GDP; the economy wasn’t growing fast enough to service its debt. The Fed responded by slashing the Fed Funds rate to just under the nominal GDP to spur economic growth. This caused companies to take their money out of cash reserves (read: the bank) and into capital investment (read: plants, machines, equipment). That capital investment takes time so the Fed’s rate cuts take 12-18 months to have an effect. The Fed fine tunes the economy in a slow and deliberate manner, like the captain of an ocean liner.
The nominal GDP growth rate target for the Fed has been 5%. When it approached 7% in 2004, what do you think they did? They raised the Fed Funds rate 13 times in a two year period from a low of 1.0% to the present day 5.25%. That brought nominal GDP under control but it took 12-18 months for the economy to feel the effect. What happened in late 2005 through 2006? Asset prices, most notably, housing prices, declined.
So where are we headed now? Well, the third quarter of 2006 produced an annualized nominal GDP rate of 3.8%, well under the 5% target. This means that if Fed Funds remains at 5.25%, we’ll be in hock to the tune of 1.5% a year. Think of this imbalance as a huge negative amortization loan; we’re just tacking debt onto the balance.
So what’s a new Fed Chairman to do? Well, if he’s Ben Bernanke (and he is), he watches the next quarterly release to see if nominal GDP is truly slowing or the third quarter number was an aberration. IF, nominal GDP is slowing, expect the Fed to start an aggressive rate cutting campaign to just under the nominal GDP rate. He must cut if he wants to establish financial harmony in the nation’s economy. This means that asset prices (read: house prices) will start an upward trend some 12-18 months later.
What does that mean to the American homeowner? Well, if the Fed cuts Fed Funds to a 4% rate, their home equity lines of credit (HELOC) rates should drop some 1-1.5%. Adjustable rate mortgages (ARM) should drop some 1-1.5%. Fixed rate mortgages, however, are artificially low due to the “global savings glut”, a phrase coined by Bernanke, and should drop to just under 6%.
PLAN OF ACTION: Consider that housing prices may be reaching the bottom of the trough in the next 4-8 months. Mortgage rates could be materially lower by this time next year (1% or more). The Fed may be signaling that the time to buy homes with an ARM hinges upon the first quarter 2007 nominal GDP rate.
NVmike says:
There’s a ton of wishful thinking in that crystal ball, Brian. The message from Bernanke on rates is ambiguous, at best.
Aside from possibly lower interest rates, what indicators do you see pointing to improvement in the next 4-8 months?
Please share; all I’ve been seeing are data that point to continue degeneration in prices and volume through the end of ’07, at least.
February 2, 2007 — 10:39 am
Josh B says:
I think it’s safe to assume that if the Fed raises rates the opposite of what you’ve written would happen. If it’s not please let me know.
Can you tell me your opinion of what the effect of unchanged Fed rates would be over the next six to 12 months?
Thanks for the insightful post
February 2, 2007 — 11:14 am
Brian Brady says:
Thanks for both of your comments:
“The message from Bernanke on rates is ambiguous, at best.”
not really, Mike. He’s watching nominal GDP like a hawk. Keep your eye on that leading indicator to cue from the Fed.
“Can you tell me your opinion of what the effect of unchanged Fed rates would be over the next six to 12 months?”
If nominal GDP is at 5%, and Fed Funds is at 5.25%, rates should be steady. The imbalance causes Fed action
February 2, 2007 — 4:00 pm
NYCJoe says:
Brian:
Good post, as usual.
I’m not sure I agree with you though on this:
I’m not sure I see how the Fed can do that without risking a run on the dollar. Remember, those interest rates are being paid to people (read: Foreign Central Banks (read: China, India, Japan)) in order to get them to buy our Treasuries and fund our deficit. If the Fed goes and starts cutting those rates, the same FCBs may decide that now is a better time than later to start shifting some reserves in other currencies, like euros.
A few years ago when the euro was a joke and the yen was even funnier, that wouldn’t happen. But the euro rates have been rising (and so has the yen), and any cut in the Fed Funds rate would narrow the spread even further.
Basically, the fed has to decide between enduring a recession in the U.S. vs. pissing off the foreign banks and causing a dollar run.
I think they’ll vote in favor of a recession limited to the US.
February 2, 2007 — 5:01 pm
Brian Brady says:
Joe:
You’re dead-on with that analysis. That’s the global savings glut Bernanke talks about. I think (and that’s just me) that it will be limited to the long end of the yield curve and that there is room to cut short-term rates…BUT…we’ll see.
Good comments!
February 2, 2007 — 5:41 pm
NYCJoe says:
Brian,
Even if you’re right about the activity being relegated to the long end of the yield curve, the resulting turmoil in the dollar itself would not be limited to that space. Plus, I didn’t even discuss the effects of the concomitant inflation that would accompany the Fed’s rate cutting actions. That’s another whole can o’ worms.
I’m also curious why you think that:
because mortgage rates are only one determining factor of housing prices. There’s still a huge supply out there (which is being understated due to the fact that cancelled orders are not added back into standing inventory) and new lending guidelines in sub-prime have the potential to wipe out 25% or so of available demand. Throw in skyrocketing property tax in places like the Florida, the Carolinas, Mass… there’s a bunch of issues that can keep prices under pressure for quite some time.
February 2, 2007 — 9:28 pm
Brian Brady says:
Joe (and Mike):
I want t post on this over the weekend. It’ will give me a chance to expand on the answer and initiate some good discussion and comments from both of you.
I invite you to e-mail me thoughts by clicking my name on the right. I’ll probably post Sunday night or Monday morning. Mike, I might agree with you that volume should lighten and prices could decline but they WILL bottom; lower mortgage rates opens up tremendous affordability.
Joe, I think the inventories are shrinking in certain markets (we certainly see that here in San Diego County if you remove the downtown condo market)
Again, I invite comments vi e-mail (or here) for consideration for the Sunday night thoughts.
February 2, 2007 — 11:09 pm
NYCJoe says:
Brian,
Was going to email you, but thought it would be better to have it recorded on the thread for discussion. I’ve got three thoughts on inventory for your post:
(By the way, I agree that inventory appears to be going down, but you have to ask yourself why that is.)
1: Inventory is already understated by the fact that cancelled orders don’t get added back in to the official government measurements. Given that cancellations are running at almost 40% for some of the larger builders, this equates to thousands of homes.
2: Some sellers are simply de-listing and waiting for spring. When spring comes, inventory will inflate again as many of these sellers re-list.
3: The effect of foreclosures on inventory is more likely to rise than fall, since a) more ARMs will be resetting and b) newer guidelines will cause more lenders to take a stricter approach to lending, removing significant demand from the market. This will cause more teetering sellers to default as they are unable to find buyers.
Now, I’m not intimately familiar with the San Diego market, so these factors may be greater or smaller in your neck of the woods.
Looking forward to your post.
February 4, 2007 — 12:12 pm
NYCJoe says:
Brian,
Case in point, by the way.
Looks like San Diego will be getting some new inventory after all.
February 4, 2007 — 1:10 pm
Brian Brady says:
The first round of ARM adjustments are disproving his theory, Joe. There are about 3000 loans a month resetting in SD. The first “big” month was Oct, 2006. Over 2500 reset, and the NOD rate for those loans is below 3%. It appears that many refinanced into a new loan. Now, your theory could hold water 12 months from now..unless…
The Fed cuts rates and the market firms up.
February 4, 2007 — 1:30 pm
NYCJoe says:
As they say, Brian, a full game is nine innings.
I think Cagan’s point was that we’re only just now beginning to enter the up-curve of resets. I’d be rather reluctant personally to make a call on whether a theory is right or wrong based on 2-3 months of data.
In any case, there’s no way to look at those numbers without a shudder. Even if he’s off by a big margin, say 10 to 20%, that’s still a big number of loans that are potentially in trouble.
Yes, you’re right, it’s still just a theory, and we won’t know for sure until 6-12 more months from now. But you have to admit, the early returns aren’t encouraging. At the very least, storm clouds are gathering. And that’s just SD.
You know, thinking more about it, I don’t see how the Fed cutting rates would have much of firming effect. Let’s suppose the Fed gets aggressive and trims by 500bp. Let’s suppose further that this causes the bond market to sell off, because holders decide to dump their treasuries.
Nothing major, mind you, but a sell-off nonetheless. That would cause prices on the 10 year to drop, which would in turn cause yields (and thus mortgage rates) to rise, not firm. Remember, the Fed has little to no control over the long bond market, as we saw during the last 15 hikes, when the long end barely budged. Most of their influence is in the short end, from the 3 month to the 2 year.
The Fed has spent the last year jawboning about inflation this, inflation that. If they suddenly go and cut rates, inflation will be that much more of a problem. I doubt that many 10yr holders are just gonna sit back and eat that.
And didn’t some Fed governor just recently say that the Fed was more likely to tighten than ease?
February 5, 2007 — 11:25 am
NYCJoe says:
Sorry, meant to say by 50bp. Man, 500bp sure would be aggressive! 🙂
February 5, 2007 — 11:31 am
NYCJoe says:
Fed’s Plosser says more tightening may be needed
Plosser is not yet a voting governor, which is probably why he feels safe talking like this.
Still, this is more evidence that the Fed is looking to tighten, not relax rates.
February 7, 2007 — 9:17 am
Brian Brady says:
Joe:
I think you miss my point here. There is NO bias at the Fed right now. They are holding steady while keeping a cautionary approach to inflation.
My point is this. While everyone is focused on the topical statistics, the nominal growth in GDP/Fed Funds ratio needs to be in harmony. Each time it hasn’t, the Fed reversed course or accelerating the corrective path to achieve balance between those two numbers.
I believe that the nominal GDP number will weaken. IF I am correct, the Fed must cut Fed Funds; it is an historical fact. I hear the bias out there but I’m sticking with my thought that the economy (as measured by nominal GDP) is weakening.
Perhaps Bill gross can explain it better:
http://www.pimco.com/LeftNav/Broadcast+Center/Bill+Gross/Bill+Gross+Jan+04+2007.htm?spd=500k
February 7, 2007 — 7:10 pm