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The Housing Market Isn't as Strong as You May Think

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) rebounded by 0.24% in Wednesday early afternoon trading following the triple-digit sell-off on Tuesday.

The talk on the Street this week has been in large part dominated by interest rates. More specifically, when are rates going to rise, and would that finally kill the bull market?

The conversation has rightly focused on the Federal Reserve's dual mandate of inflation control and optimizing the labor market. Both of those economic metrics have seen strong improvement over the past few months, with the unemployment rate now at 6.1% and inflation slowly creeping to the Fed's 2% target.

US Unemployment Rate Chart

US Unemployment Rate data by YCharts.

The argument goes that because these two factors are both finally reaching a healthy level, the Fed will begin to raise interest rates and return to a more historically normal monetary policy. 

Rising interest rates are a headwind on growth as capital becomes more expensive, so the central bank must act delicately here to avoid sending the U.S. back into a recession. The higher rates should help keep inflation from getting out of hand, but an economic slowdown could hurt the recovering jobs market.

One big issue that isn't getting headlines this week
Unfortunately for the Fed, the decision on when and how to raise rates is not a two-variable equation. The U.S. economy is so complex that pulling one lever (like interest rates) can have unintended consequences elsewhere in the economy. Unintended consequences that could throw a monkey wrench into the whole machine.

The interest rate conversations this week have centered on inflation and jobs, but the real estate market is just as critical. Don't forget, it was a real estate crisis that instigated the entire Great Recession.

Why have we suddenly lost sight of housing? Because the data for new-home sales and existing sales has been very positive lately, following the ugly first-quarter disappointment.

Sales of new homes in May rose over 18%. Existing-home sales were up 4.9%. Those are huge numbers. Housing must be back on fire!


US New Single Family Houses Sold Chart

US New Single Family Houses Sold data by YCharts.

Not quite.

Taking into consideration these hot numbers and the revisions to previously reported sales figures so far in 2014, the residential housing market looks only marginally improved from 2013. 

That huge bump in May? That's just a short-term movement caused by the pent-up demand from February and March. When the weather was cold, homebuyers were content to bargain hunt online instead of signing on the dotted line. When the weather finally thawed, those buyers hit the streets and made up for lost time.

Now, circling back to interest rates. If the housing market is just mediocre, what happens when mortgage rates finally start to rise (which they absolutely will as the Fed raises the federal funds rate and continues to wind down quantitative easing)?

Housing affordability will decline dramatically. The average U.S. mortgage rate for a 30-year loan is currently 4.12%, according to Freddie Mac. For a $200,000 loan at those terms, the monthly payment comes to $969. 

If mortgage rates rise to 6.75%, where they were in 2006 and 2008, that same loan would now carry a monthly payment of $1,297. That's a 34% increase in the monthly payment, more than enough to prevent many buyers from being able to afford that new home.

US 30 Year Mortgage Rate Chart

US 30-Year Mortgage Rate data by YCharts.

Rising rates are not just about an improving jobs market and inflation
The Federal Reserve will raise rates. Most experts think that change in policy will occur sometime in the next 12 to 18 months. When it happens, the underlying fundamentals driving the U.S. economy will look strong.

We know that because it's the nature of the decision to change policy; the low-rate policy was designed to spur growth in the wake of a once-in-a-generation economic crisis. With recovery comes a return to normalcy.

But when rates do begin to rise, a cascade of consequences will change the economic dynamics around the country. Growth will slow. Loans will become more expensive. The yield landscape for investors will change virtually overnight.

The hope is that the nation's economic engines will be strong enough to power through those headwinds. The risk is that still-fragile markets, like real estate, will shatter under the weight.

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