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The BIG Question: Will Rising Interest Rates Derail the Housing Recovery?

June 27, 2013 1:55 PM EDT
For Wall Street and Main Street alike, last week's news from the Federal Reserve that QE will likely taper later this year and end in mid-2014 has them thinking about one crucial item - Will rising interest rates derail the housing recovery?

Signs are already showing that higher mortgage rates have halted the recent improvement in purchase mortgage applications. The chart below from BofA Merrill Lynch Global Research illustrates the recent drop-off.



While a negative impact on refi application activity would be expected on the higher rates, the drop off in purchase mortgage applications bears watching, BofA Merrill Lynch's strategists led by Michael Hartnett said. "If purchase demand falters in coming weeks, that could be a more concerning trend," he said.

However, other research from BofA Merrill Lynch suggests that rising interests rates will not impact the housing recovery.

BofA Merrill Lynch's Chris Flanagan notes that most of the academic literature on home price models shows that, other than on a very short term basis, mortgage rates are not an important determinant of home prices. Mortgage rates are a variable in BofA Merrill Lynch's home price model but has a relatively small statistical significance. "Overall, we believe that other variables, such as income growth and inflation, tend to capture the impact that one might think mortgage rates would have in determining the fair value for home prices," he said.

Flanagan said a look at recent history shows that interest rates have had little impact on housing. He explains, "The ending mortgage rate for 2011 was 4.01%. Yet the home price growth was -3.4%. In 2013, the mortgage rate will likely be somewhere between 4% and 5%, yet home price growth is expected to be roughly 12%. In other words, with roughly the same mortgage rate, price growth was -3.4% in one year and 12% in another year." The difference, he explains, is due to the different economic environment, including the variables such as housing inventory, distressed sales, and price momentum.

So what is the biggest factor in determining home prices? It's affordability, according to the firm. And, recent concerns that rising mortgage rates will erode affordability is "a significant misperception." What is being lost in the discussion, according to the strategist, is that we are still at record levels of affordability and there is substantial room for increases in both home prices and mortgage rates before affordability heads into what we think would be a danger zone.

Flanagan believes there is ample room for both higher home prices (+20%) and higher mortgage rates (+150 basis points) before housing affordability destabilizes the housing recovery.

The firm revised up their forecast for home prices from 8% q4/q4 growth this year to 11.8%. They expect the pace of appreciation to slow into the second half of the year, owing in part to lower affordability, which will hold back some of the rapid momentum in prices. For 2014, they maintained their forecast that home price appreciation will slow to 6.5%.

Commenting on the potential of another housing bubble forming, the firm said we are "decidedly" not entering one.


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