By Ryan Casey Stephens, FPQP®
Special Contributor
As we step into a new year, a palpable sense of anticipation and fresh opportunity fills the air. The economic landscape of the past 12 months undoubtedly presented its share of formidable challenges, impacting businesses, households, and individual financial plans across the nation. Yet, as I survey the horizon, I find myself embracing an increasingly optimistic and bullish outlook for the season ahead, particularly concerning the trajectory of our economy and the housing market. It’s an outlook that stands in stark contrast to the uncertainties that clouded our predictions just a year ago, underscoring the dynamic and often unpredictable nature of economic cycles. Therefore, while I share my assessment with conviction, I encourage a discerning perspective, recognizing that the future is always unfolding. Nevertheless, I firmly believe that 2023 is poised to be a pivotal year marked by significant stabilization and steady improvement across various sectors. Let’s delve into the core reasons underpinning this positive forecast in this week’s Three Things to Know.
Understanding the Inevitable: A Necessary Economic Reset
The economic signals surrounding us are clear and increasingly undeniable, pointing towards an imminent period of contraction: a definite, and dare I say, beautiful and needed recession. Data consistently reveals that American savings accounts have significantly dwindled, with over $800 billion evaporated from household reserves. Concurrently, credit card debt in the U.S. has experienced the most substantial increase in two decades, reflecting a growing reliance on credit amidst inflationary pressures. Furthermore, key indicators such as existing home sales and vehicle sales are unequivocally contracting month over month, signaling a slowdown in big-ticket consumer purchases. Perhaps most telling, all measurable yield curves, from the 2-year/10-year Treasury spread to others, are deeply inverted – a historical harbinger of economic downturns. While official declarations often lag, the evidence strongly suggests that if we are not already navigating a recession, we will be imminently. The formal acknowledgment may not arrive until well into the new year, but the economic undercurrents are undeniable.
While the term “recession” often evokes apprehension, it’s crucial to understand why, in the current context, these facts and the myriad of other indicators pointing to a shrinking economy are, in fact, wonderful news. We’ve emerged from a period characterized by deeply flawed Federal Reserve monetary policy, which involved unprecedented levels of money printing, expansive stimulus packages, and excessively garish easing measures. This cocktail of policies inadvertently fueled the worst inflationary environment our nation has grappled with since the 1980s, eroding purchasing power and creating significant financial strain for families and businesses. A slowing economic environment, therefore, represents our most viable path to cooling the white-hot flame that has been steadily burning away our hard-earned money and savings. As we progress deeper into the new year and the anticipated recession takes hold, we ought to observe increasingly pleasing inflation readings each month, laying the groundwork for a more stable and sustainable economic recovery. This economic reset, though potentially uncomfortable in the short term, is a necessary corrective measure to restore balance and long-term health to our financial system.
The Ripple Effect: Lower Inflation Paves the Way for Reduced Interest Rates
The battle against inflation is multifaceted, and slower consumer spending is certainly a key player. However, another significant and often overlooked factor poised to exert considerable downward pressure on inflation comes from housing costs. It’s a critical point to grasp: more than a third of the entire Consumer Price Index (CPI) inflation report, the primary gauge for measuring inflation, is comprised of “shelter costs,” with rent being a prime example. The way this metric is calculated in the CPI is crucial; it averages the last year of rent cost appreciation, meaning it’s a lagging indicator. One year ago this month, rental costs were skyrocketing, exhibiting an alarming 18 percent year-over-year increase. However, by last month, that explosive growth had significantly decelerated, falling to a much more manageable 4 percent. Given that residential leases are predominantly signed on an annual basis, we should continue to see dramatic monthly improvements in this single metric, which, by itself, constitutes just under half of the total CPI inflation data. This delayed but significant cooling in shelter costs will be a powerful force in bringing overall inflation down.
Now, let’s connect this to interest rates, particularly mortgage rates. For the better part of the last 35 years, the average 30-year fixed mortgage rate has consistently maintained a spread of approximately 1.75 to 2 percent above the 10-Year Treasury yield. This relationship has shown very little deviation from that established rule over decades, serving as a reliable benchmark. However, throughout much of last year, this spread aberrantly widened to an astonishing 3 percent, leaving many questioning the deviation. What accounted for this unusual jump? In essence, mortgage rates increased so rapidly that mortgage servicers and lenders grew increasingly concerned about the longevity of these high-rate loans. The prevailing market sentiment was that a significant portion of borrowers securing mortgages at 7 percent or higher would likely refinance within a year or two as rates inevitably corrected. This expectation of rapid refinancing meant there would be limited long-term profit opportunities from holding these loans. To compensate for this anticipated loss of future revenue, lenders effectively added an extra percent onto mortgage rates, creating that unusual spread.
As we transition further into the anticipated recessionary environment, the 10-Year Treasury yield should naturally fall, as it typically does during periods of economic contraction and flight to safety. When this occurs, two significant factors will converge: the base rate (10-Year Treasury) will decline, and critically, the extra 1 percent margin that was added to mortgage rates to account for expected refinancing should evaporate. This means that mortgage rates are poised to fall not just in line with the 10-Year Treasury, but potentially even faster, as that additional premium dissipates. The exciting result of this convergence is the distinct possibility of seeing 30-year fixed mortgage rates drop into the desirable range of 5 to 5.5 percent by late spring or early summer. This significant reduction in borrowing costs would inject much-needed vitality into the housing market, making homeownership more accessible and affordable for a broader segment of the population.
The Housing Market Unleashed: Opening the Floodgates for Eager Buyers
The combination of astronomically high mortgage rates and rapid home price appreciation over the last six months has regrettably acted as an impenetrable barrier, effectively locking a substantial demographic of aspiring homebuyers, particularly younger individuals and families, out of the market. The sheer scale of this suppressed demand is striking. We can observe this phenomenon through the metric of “household formations,” which essentially tracks young people transitioning from their parents’ homes to establish independent households. Historically, this figure averages around 1.7 million new households annually. However, in the past year, we witnessed a stark decline, with just 1.3 million new formations. This deficit of hundreds of thousands of new households represents a massive, pent-up demand—a generation of young Americans metaphorically sitting in their trenches, patiently waiting for the economic “machine gun fire” of high rates and prices to subside. They are ready and eager to enter the market once conditions become more favorable.
Looking ahead, the consensus among industry experts and leading economic forecasters suggests a promising shift. Predictions for home price appreciation are now hovering around a more sustainable 4 percent, a significant departure from the double-digit increases we’ve seen. Simultaneously, mortgage rates are projected to stabilize somewhere between 5 and 6 percent, aligning with the earlier discussion about declining inflation and the narrowing spread. At some point within this year, we are destined to reach a crucial equilibrium. This is the point where home prices cool to more reasonable levels, and critically, mortgage rates ease just enough to permit these thousands, if not hundreds of thousands, of eager buyers across the nation to confidently re-enter the housing market. In simple and actionable terms, improved affordability will serve as the potent trigger for the much-needed pickup in real estate activity that we all anticipate and desire. This isn’t just a hopeful projection; it’s a fundamental economic release valve for suppressed demand. So, to every real estate professional who has navigated these challenging waters – be profoundly encouraged. If you’ve diligently worked and persevered to this point, you are not just surviving; you are nearly out of the woods and perfectly positioned to thrive in the rebounding market ahead. Prepare for a surge of activity as the floodgates open, bringing a renewed dynamism to the real estate sector.
Ryan Casey Stephens FPQP® is a mortgage banker with Watermark Capital. You can reach him at [email protected].