Investing in the market over the past decade has been nothing short of a rollercoaster ride, with all-time highs giving way to decade-lows in 2009, only to see new all-time highs once notched by the Dow Jones Industrial Average (^DJI +0.50%) and S&P 500 (^GSPC +0.83%) just four years later.
Source: Great Valley Center, Flickr.
Arguably, everything has gone right for investors and the companies that make up those indexes over the past four years. The unemployment rate has fallen in a slow but steady manner as part-time hiring has really picked up year-to-date. Similarly, record-low lending rates have spurred businesses to expand and have allowed both consumers and business to refinance their existence debt at substantially better interest rates. This is one of the many reasons the housing sector has been able to find a bottom and why homebuilders are now able to utilize low inventory levels to their advantage to improve their pricing power. Even the U.S. budget deficit has narrowed from four years ago, as the sequester has required the removal of $85 billion in spending from the federal budget.
It may not seem like the perfect scenario for the U.S. consumer, but all things considered, they've been absolutely spoiled since the recession. The Federal Reserve has enacted not one, not two, but three separate monetary easing programs catered to buoying a still fragile U.S. economy, and it has kept its federal funds target lending rate at a historic low to spur commercial and personal spending. And how, you ask, has the consumer acted since May? Like a spoiled brat!
The U.S. consumer says, "I'll do what I want!"
Since the beginning of May, when the Federal Reserve first hinted that ongoing positive economic data may cause it to begin paring back its $85 billion in monthly bond purchases, 30-year mortgage rates have increased by roughly 120 basis points to 4.57%. Over that same time span, mortgage applications, which include refinancing as well as new home loan originations, have fallen in 15 of the past 18 weeks and are now 59% off their early May high. Furthermore, August's U.S. retail sales data pointed to an ongoing theme from teen retailers that consumer spending is weak.
On one hand, I can empathize with American consumers in that they want the best possible deal for their hard-earned cash. Why pay 4.5% on a mortgage when you could have gotten it for 3.625% just five months ago?
Source: Freddie Mac; each date represents an advancement of two years (thus 04/02/1971, 01/05/1973, 10/11/1975, and so on).
Then again, look at that chart and tell me exactly how the consumer is getting a bad deal. The minuscule blip on the far right is the latest "spike" in 30-year mortgage rates, and while we're sitting at our highest interest levels since April 2011, the current rate of 4.57% is about 200 basis points below where we were when the market peaked in 2007, around 375 basis points lower than right before the dot-com bubble burst, and close to 600 basis points lower than when the Gulf War scared investors back under their bedsheets in 1991. At no time in history has the Fed catered to the needs of the American consumer as it's done over the past couple of years, and consumers are sticking their noses up in the air at even the slightest bump higher in lending rates.
How the spoiled U.S. consumer could kill this rally
Why is this a problem, you ask? For one, consumers' unwillingness to accept historically low lending rates could stymie any chance the homebuilding industry has of getting firmly back on its feet. Homebuilders have been purposely keeping their inventory levels down to maintain pricing power and instill a sense of urgency into homebuyers -- yet a 59% decline in mortgage applications is certain to ruffle some feathers in the housing industry. The larger and more diversified players, such as D.R. Horton and Lennar, probably aren't too concerned, but higher-end homebuilder Toll Brothers (TOL 0.21%) should be concerned. Focusing on luxury homes means the ability for some of Toll Brothers' clientele to pay for homes in full. However, for the majority of homebuyers who do choose to finance their purchase, higher interest rates could quickly price potential luxury-home buyers out of the market and hurt Toll's bottom line.
Another loser here would be banks. Now, keep in mind that banks would benefit from higher interest income earned on deposits and investments, and would potentially reap higher interest income on credit cards and loans. The concern is that higher interest rates will crush new loan originations and refinancing, as the mortgage application data has clearly shown. The end result has been layoffs throughout the mortgage service sector. Bank of America (BAC 1.52%) let 2,100 people go earlier this week because of weak mortgage refinancing demand, while Wells Fargo laid off 2,300 people from its mortgage service division last month. Although higher rates will eventually favor banks such as B of A, the near-term rapid decline of mortgage service fee revenue could hamper its bottom-line results faster than it can reap the rewards of higher rates.
Another potential loser here would be retailers (surprise, surprise, right?). The retailers in question could represent everything from automakers such as General Motors to jewelry stores such as Zale (NYSE: ZLC). Why bother mentioning GM and Zale, two completely unrelated companies? Because these two companies make products -- cars and jewelry -- that are often purchased with credit. As interest rates rise, the amount that GM's finance arm or that Zale's store credit card charges is probably going to rise as well. If consumers are proving this stubborn about a 120-basis-point rise in 30-year mortgage rates, imagine how quickly they may holster their disposable cash if businesses raise their credit card APRs as well. For a company like Zale, which took a bridge loan in 2010 just to keep afloat, it needs interest rates to remain low so buyers aren't discouraged from charging to their Zale card at the current 23.73%-28.99% variable interest rate.
There's obviously a lot on the line for the Federal Reserve as it considers paring back its monetary easing program known as QE3. What we do know is that the Federal Reserve simply doesn't have the funds (or need) to continue introducing free money into the economy each month. In other words, the artificial interest-rate buffer that's helped keep lending rates low is going to go away whether consumers want it to or not and, in many cases, they'd be absolutely foolish not to take advantage of these historically low lending rates currently available. The problem is that if consumers don't realize this, we could be in for big trouble.
