The Big Picture: Mortgage Rates versus Fed Fund Rates

The Big Picture: Mortgage Rates versus Fed Fund Rates

A lot of folks have trouble with the idea that long-rates have held steady or gone down while short rates have gone up. I don't.

The very reason the fed has raised short rates is to fight future inflation; long rates forecast future inflation. Why shouldn't the market forecast of future inflation move down when it is clear that the FOMC is earnest about fighting future inflation. Most investors appreciate the fact that the stock market discounts the future. What is wrong with Greenspan and company raising rates well before inflation hits? So far this cycle, the FOMC has performed masterfully. The US economy is enjoying extraordinary growth and low inflation. What more can consumers, businesses or investors ask for?

Most folks incorrectly focus on commodity prices as the key to inflation. The world has changed. In the old days, the US was a manufacturing based economy. Now it is a service based economy. The current average cost of products is about 85% labor. The cost of services are often more than 85% labor. We will not have high inflation unless unit labor costs are rising at a fast pace. The FOMC is targeting something like projected unit labor costs. The Fed is trying to stay ahead of the curve. So far, the FOMC is clearly doing a great job!

All the talking heads can project future inflation and then argue about whether the FOMC is being too aggressive or not but we will know that the FOMC has been too tight only if the economy actually slows below trend. The only thing we can say now is the policy of the FOMC six months to a year ago was right on the money!

The current game being played by talking heads is to site backward looking numbers to prove that the FOMC is wrong. The revisions to GNP show that real growth is growing faster than the long-term history of our nation. The revisions to inflation show that the total number is not bad at all.

Much has been made about the revisions to growth. The revisions simply accounted for faster home sales than were originally reported. These numbers have always been subject to revisions for months and even years.

Conditions continue to be almost perfect for second home purchases. Second homes are now a significant and growing share of total home sales. Second homes now account for more than 6% of all mortgages. Second homes are a little bit like IPO's. IPO's are riskier stocks than seasoned securities and you have to "know" someone to get an allocation of shares. Similarly, you have to "know" someone to be allocated a preconstruction condo in the hottest markets. With second homes growing as a percentage of total home sales, it is natural that investors account for a growing percentage of mortgages.

Investors buy pre-construction, hold for a year to get long-term capital gains and then sale to boomers who can afford second homes. Builders must have 60% of high rise buildings sold before construction can start. Therefore, they offer good prices to those willing to buy pre-construction.

With a solid trend in place for boomers to own second homes, it is natural for our economy to be revised upward due to stronger than expected home sales. The talk about the real estate bubble has done the job of taking the edge off the boom but "the trend is your friend--never fight the trend". My family is gradually selling real estate into the rising market. This is the same way prudent investors scale out of heavy stock positions that have exceeded expectations. My family would like to sell all properties at the top but we are realistic investors. We expect to sell some properties too early and some too late.

A lot of folks don't remember the housing bubble we had in the mid to late 1980's but this one is similar. The fact is that prices of homes did not drop during the early 1990's the way commercial real estate dropped. Second homes are more volatile than first homes so resort areas may see actual drops in prices during the next real estate recession; not from current prices but from higher prices. My guess is the next real estate recession will occur sometime between 2009 and 2013. This is consistent with the history of an average of about 20 years between real estate recessions. The last real estate recessions were in 1990-91 and in 1973-74.

Calling the top of any market is very difficult. Bottoms are easy relative to tops. Bottoms are likely to be V shaped where as tops can take a long time to develop. Conditions are nearly perfect for continued high growth in real estate prices. Mortgage rates are very low, demand is very high and productivity has dramatically lowered the costs of construction. One can afford very much more home today than one could just a few years ago.

THREE LEGS OF THE HOUSING STOOL--COST OF MONEY--COST OF CONSTRUCTION--DEMAND

COST OF MONEY

Only a few years ago, folks were quick to trade-up to a bigger home when mortgage rates dropped below 9%. The cost of a $500,000 mortgage dropped to only $4,023 per month. Today the same $500,000 at 4.5% cost only $2,533 per month! THIS IS LIKE A 38% OFF SALE! THE SAME AMOUNT OF MONEY COST ONLY 62% OF THE PREVIOUS COST. The price of this money is now less than half of the costs during the housing boom of the 1980's! A 50% OFF SALE!

COST OF CONSTRUCTION

The changes in the construction costs of homes in the past 15 years are almost as big as the changes made in car construction by Henry Ford. When Ford invented the assembly line, he was able to double the pay of workers while cutting the cost of cars in half! Ford put thousands of companies out of business by taking huge market share. Millions of small home builders have been put out of business in the past 15 years as the "big boys" have turned home building into a science. Those of you who purchased and rode the home building bucking broncos have made fortunes. My family enjoyed huge profits on shares in this area but I must admit that we did not buy enough shares and we sold too early.

Even after years of dramatic productivity enhancements, most folks do not get the fact that in real dollars one can buy double the house today for the same real amounts.

DEMAND

We currently have more people in the United States who are at peak earnings than at any other time in history. Peak earnings typically happens for 50 year old workers. There are currently 76 million people between the ages of 46 and 59. The children have grown and the parents suddenly discover they are relatively rich. Parents are prime prospects to buy second homes and their children (the echo boomers) are at prime ages to buy first homes. The prior baby boom generation (those born after World War I) is transferring wealth at levels never transferred before. It is common for boomers to pass along an inheritance to an echo boomer for the purpose of buying a house.

The Elderberries cartoon makes another great point. It says that according to the UN 58 million people are between 80 and 90, 7 million are aged 90 to 100, 100,000 are between 100 and 110 and Dusty did not want to know how many were over 110! The point is that 30 years ago if grandma was still living at 70, she was probably living in the home of a relative. My Mom is 83 and she owns four homes! She bought three of them as first homes but kept two of them as rental property after she moved. She charges below market rents but the income is still better than bonds at 4%.

SUMMARY

Investors should not worry so much about FOMC policy. We have a master in charge who is standing on the shoulders of the past Chairman. During the Volcker-Greenspan years, short rates have gone from 21% to 3.25%. The current whining about an increase from 3% to 3.25% is unwarranted. The cost of money is very low, the cost of home construction is the lowest ever in real terms and demand has never been higher. While it is difficult to call any top, it is clear that we are not at a top at this moment. Indeed we are nearing the end of a FOMC tightening cycle which means we are closer to a medium term bottom than to a top. When it becomes clear that the FOMC has completed the job of beating back inflationary pressures, we are going to see a beautiful stock market. Ironically, the end of the short-term rate increases will mark the beginning of the end of the housing boom. Long term mortgage rates will go up when the market perceives that the FOMC is going to let the economy run. Business construction will increase and squeeze out the home buyer.

BUY THE BULL NOW! INVESTMENT CONDITIONS CANNOT GET MUCH BETTER! STOCKS ARE CHEAP! A CHART OF HISTORICAL P/E RATIOS SHOWS THAT THE S&P 500 OFTEN TRADES AT MULTIPLES OF 25, 30 AND EVEN 35 WHENEVER TEN YEAR BOND YIELDS ARE BELOW 5.5%. INDEED IT IS RARE FOR P/E RATIOS TO BE ANYWHERE NEAR CURRENT MULTIPLES AT EVEN 6% OR BELOW! INDEED IT IS VERY RARE FOR TEN YEAR RATES TO BE SO LOW IN THE FIRST PLACE. BONDS OFFER VIRTUALLY NO COMPETITION FOR REAL ESTATE! STOCKS ARE CHEAP RELATIVE TO REAL ESTATE! AVOID BONDS, REDUCE REAL ESTATE EXPOSURE, BUY STOCKS!