House Prices Versus Interest Rates

FRED Graph - House prices semi-annual since 1981

Interest Rates (10 year Bond yield since 1995)

My view:

I would like to remind my readers of the close connection between interest rates (bond yields) and house prices (asset prices).

Because housing is typically highly levered, it is quite sensitive to change in interest rates.

As we follow the top graph, we note that prices surged from 1996 to 2007 by over $100,000 to $250,000.

We note that interest rates represented by the 10 year bond yield as our proxy, plummeted from 6.5% to 3.5% over the same time period.

Since then, house prices pulled back strongly in the 2008 housing crash and have subsequently rebounded near previous highs.

During this time, interest rates have dropped even further from 3.5% to the current 2.2%.

Those of you familiar with investment analysis will note a troubling trend.

As the interest rate fell, asset prices (houses) moved inversely as we would expect.

The 2007 highs in house prices took place with 3.5% rates, but the current similar prices developed under the lower rate of 2.2% presently.

All things being equal, if rates were to climb back to the 3.5% level of 2007, which seems quite reasonable under the current circumstances, it mean a significant pullback in house prices.

Under this scenario, the $250,000 house at 2.2% 10 year bond yields, implies a value of $157,000 (a 37% drop) at a 3.5% rate.

Obviously the 10 year bond rate does not immediately tie into mortgage rates as many mortgages are fixed for longer periods of time.  But for new mortgages, and those coming up for renewal, higher rates have a large impact on affordability.  So a 30% plus drop in prices is perhaps unlikely, while a lesser 10 to 15% drop is quite conceivable.

Overall, we may be looking at a second dip in housing prices over the next few year in the United States as the Fed fails in its attempt to reflate the housing bubble.