Why Housing Looks Rickety

Business Week reports:

The Fed may not stop after just one more rate hike in May, despite the hints in the March meeting minutes. And even if the Federal Reserve does pause in raising the short-term rates that it controls, long-term rates may well keep rising anyway. That would happen if buyers of Treasury bonds and mortgage-backed securities get nervous about the Fed's commitment to inflation-fighting and sell. When bond prices fall, interest rates automatically rise. And borrowers, including home buyers, pay the price.

Until recently, the housing market has been strangely insulated from the Fed's rate-hiking campaign. In June, 2004, right before the Fed began hiking, the federal funds rate that it controls was at an extremely low 1%, and the effective rate on 30-year fixed rate mortgages (factoring in points) tracked by Freddie Mac Corp. was at 6.29% -- a gap of more than 5 percentage points. The Fed proceeded to jack up the federal funds rate, but mortgage rates actually fell. That fueled the housing boom. It's only in the last few months that housing has clearly begun to slow down. For example, housing starts fell 7.8% in February and another 7.8% in March, according to a Census Bureau report.

Things could get a lot worse from here if mortgage rates move up in line with the increase in the federal funds rate. So far they haven't. Even though the federal funds rate has gone up by 3.75 percentage points, the 30-year mortgage rate is only 0.2 percentage point higher than it was when the Fed started raising. Diane C. Swonk, the chief economist of Chicago-based Mesirow Financial, predicts that the 30-year rate will climb to 6.9% by the end of 2006 and 7.25% by the middle of 2007. (She uses a different index that has rates at about 6.4% now.) The super-low mortgage rate "was a fairy tale environment and it had to end," says Swonk.

Anyone interested in housing and interest rates should read this one.