Mortgage Applications At 28-Year Low
Mortgage rates increased 50 basis points or 0.5% in February to average 6.71% for a 30-year mortgage. Mortgage applications are 44% lower than a year ago, falling to a 28-year low. Refinance applications are down 74% from February 2022.
A slight dip in mortgage rates in January saw a spike in home sales, but market sentiment changed, and sales dropped in February. In January, market makers misread inflation trends and expected the Federal Reserve to lower interest rates in 2023. Several banks have changed their interest rate predictions to continued tightening throughout 2023 and a possible pivot in the 1st or 2nd quarter of next year.
Market watchers believe real estate sales will be slow in the usually busy springtime. Still, prices will only move a little toward affordability in 2023. Twenty-nine analysts surveyed between February 15-March 2 believe U.S. home prices will only fall by 4.5% in 2023. Home prices rapidly grew and then dropped in 2022 ending the year 1.3% higher and 45% higher since 2020.
Economists generally believe that higher interest rates increase monthly payments and force sellers to lower prices to attract buyers. In theory, this is how the market should behave. However, the National Association of Realtors (NAR) found that 90% of major real estate markets rose in 2022 Q4 despite the rapidly rising mortgage rates in 2022. The abnormal market behavior is not a good sign for interest rates long-term. Interest rates will climb higher than most people are willing to believe and remain there longer than anyone would like. For whatever reason, the media doesn’t mention or explain the politically embarrassing mechanism why. They talk around it, probably hoping no one thinks about it too much, and throws a brick through their TVs. Too many broken TV sets aren’t good for ratings.
Debt instruments, usually U.S. Treasuries, back all Dollars the Federal Reserve creates. Financial pundits often talk about the Fed's balance sheet and its attempt to reduce it, but most people don’t know what that means. They are referring to the debt collaterals the Fed holds for money creation.
The reality is that the government created this mess by overreacting to the pandemic and quadrupling the money supply in two years. Now, we are playing a not-so-fun game of financial musical chairs to get the cash out of the system. When the Fed infuses cash into the system like during the pandemic, it buys debt instruments. When the Fed reduces its balance sheet, it sells the debt instruments into the market again to take possession of the cash. These two movements are called the Repo and Reverse Repo markets.
The Fed increased its balance sheet by nearly $17 trillion during the pandemic. Despite the 2008 meltdown, the Fed became overleveraged in mortgage-backed securities again. 30% of the money created during the pandemic was mortgage-backed securities. Ironically, the Federal Reserve now has $trillions in Treasuries and mortgage-backed securities that it can’t sell because of higher interest rates. Higher interest rates keep people out of the mortgage market, and the Fed's Treasuries would be sold at a loss. Since the Fed can’t sell them into the market to reduce its balance sheet, it has to wait for the securities to mature.
Since mortgage rates are increasing and housing prices aren't dropping, the Fed has a real problem. Rising monthly mortgage payments will push more buyers away from mortgages but not lower inflation. Fewer buyers will be in the housing market, so there will be even less liquidity in the mortgage-backed securities market. The Fed will have to wait for maturity to reduce its balance sheet because it didn't get help from the market.
Only about $35 billion per month of mortgage-backed securities (MBS) and $65 billion in Treasuries are maturing from the Fed’s balance sheet. That's only about $1.2 trillion annually, but the Fed needs to reduce it by $17 trillion. The Fed is out of options except to push interest rates higher for longer. The Fed will raise interest rates more aggressively to speed up the process of bringing inflation down, or else inflation could linger above the target for a decade or more. At the current pace, it would take the Fed about 13 or 14 years to return the balance sheet to pre-pandemic levels.
What does it mean?
The Fed can only reduce its balance sheet gradually as securities mature since selling is not an option. On average, portfolios lost between 17-20% in 2022. 2022 was the initial shock to the market, but more market decline is likely ahead. The long-tail effects of the hikes already implemented have yet to be fully felt, and more hikes are coming. Despite what the politicians say, there will be skewed housing data for several quarters, maybe years, and the Fed will have to keep raising rates. It is the only tool it has left to fight inflation.
Most people have most of their wealth in their homes and retirement accounts. For many people, their home is a significant retirement plan component. The problem is that housing may stagnate for years, leaving many retirees scrambling since liquidity will diminish in the housing market. Higher interest rates will likely continue pushing retirement account values lower, forcing many people to make hard decisions about financing their retirements.
More people are waking up to the reality that if they don't do something to protect their wealth soon, nothing may be left to protect.
There is no such thing as a free lunch. America agreed to pay the bill when the Fed quadrupled its balance sheet. America will pay the Fed bills through inflation, wealth transfer to the Fed, market losses, loss of global prestige, and higher taxes.
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