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Forget Rates: Why Housing Prices Suggest the Recovery Will Gain Strength


Our review of the data shows that prices, which are on the rise, are key to keeping the market thriving.

With QE and the Fed at the forefront of everyone's minds these days, let's take a step back and look at what's going on in housing. We know that mortgage rates have moved from December lows of 3.4% on a 30-year fixed mortgage to where we are now, which is essentially 4.625%.

We also know that roughly 70% of Americans own a home, thus constituting a very large portion of GDP -- to the tune of 17%. The "trickle-down" effects are immense, and perhaps best represented in terms of scope by the SPDR Homebuilders ETF (NYSEARCA:XHB), whose main weightings are Lennox International (NYSE:LII), Lowe's (NYSE:LOW), Bed Bath & Beyond (NASDAQ:BBBY), Mohawk Industries (NYSE:MHK), Williams-Sonoma (NYSE:WSM), Home Depot (NYSE:HD), and Toll Brothers (NYSE:TOL).

This being the case, it's only natural to try to predict where the housing market is heading, given our current environment. First, we may need a history lesson. Looking at the last decade, where housing was most definitely one of the primary issues leading up to the Great Recession, we can learn a lot about certain trends and patterns that might better help us in our current position.

Beginning in the year 2000, Alan Greenspan, former chairman of the Federal Reserve, brought about rises in interest rates several times. He believed that the economy was going too strong for its own good (remember "irrational exuberance"?) and that an increase in interest rates would help slow it down. In particular, the stock market was growing too fast, and Greenspan was hoping that the increase in rates would slow it to steadier levels. These actions taken by Greenspan were believed by many to have caused the bursting of the dot-com bubble in March 2000.

Let's take a closer look at the change in certain rates before and after the dot-com crash. At the start of 2000, discount rates were at 5.5% and increased in intervals of .25% until they reached 6.5% by the end of the year. Thirty-year fixed mortgage rates were also on the rise, reaching a max of 8.52% at the peak of the bubble. From then on, however, mortgage rates dropped until they fell to almost 5% in mid-2003. In response to the crash and the 2001-2002 recession that followed, the Federal Reserve lowered interest rates to historically low levels, from 6.5% to just 1%. By November 2002, the discount rate was at a low of .75% and the target Fed funds rate was at a near-low of 1.25%. Mortgage rates were dropping as well, seemingly in sync with the rapidly falling interest rates, as one might expect. Such a sudden and dramatic change in rates resulted in lenient lending practices and easy approval for banks to give out loans and mortgages. This sparked the beginning of the housing bubble, which resulted in some serious repercussions. Greenspan even admitted that the housing bubble was "fundamentally engendered by the decline in real long-term interest rates."

When interest rates began to rise again in 2003, it took a long time for mortgage rates to react; mortgage rates did not really begin to rise again until 2006, even though interest rates had been constantly on the rise since 2003. The yearly averages for mortgage rates in 2003, 2004, and 2005 were 5.83, 5.84, and 5.87, respectively. One can see why the argument can be made that current mortgage rates are still historically low.

All the way up until June 29, 2006, rates constantly rose under the direction of the Fed until discount rates peaked at 6.25%. With interest rates on the rise, 30-year mortgage rates peaked at 6.53% in June 2007, which was a ten-month high. This was preceded by housing prices peaking at 206.52 in July of 2006, as indicated by Case-Shiller 20-Composite Index. That's when the housing market began to crack, and it eventually shattered. In terms of housing, the resulting foreclosures increased supply, causing a drop in housing prices. Home prices continued to fall throughout 2006 and 2007, eventually becoming a major cause for the recession that began in 2007.

After the housing crash, interest rates began to steeply decline once again, mainly via the Federal Reserve's easy money policies, known as quantitative easing, or QE 1, QE2, and currently, QE3. They have remained historically low ever since. The Fed discount rate currently remains at 75 bps, and the federal funds rate is at 25 bps. Mortgage rates also fell steadily and did not begin to rise again until recently.
But now, mortgage rates are back on the rise, and there is a worry that this might stunt the housing recovery. And with housing being a key component of the health of the economy, this could be a cause for concern.
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