If the Fed is done raising rates, when will mortgage rates go down?

• U.S. home prices hit record highs in 2023¹ as a lack of supply outstripped any dent to demand that higher mortgage prices might have caused.
• The Fed may be done hiking rates but is unlikely to aggressively cut rates in 2024, in part because of shelter inflation’s large weight in the CPI basket.
• The full impact of higher mortgage rates is likely still to be felt and housing is more likely to be a drag rather than a contributor to growth in the coming year.

The U.S. residential housing market looks stuck in an uneasy equilibrium, where higher interest rates have yet to be fully felt. The S&P CoreLogic Case-Shiller Index rose steadily in 2023, hitting an all-time high in September,² even as average 30-year fixed-rate mortgages hit 8% for the first time since 2000.³

Given heighted expectations that the Fed’s next move will be to lower rates, the questions begs: When will mortgage rates go down?

We believe the Fed is likely done with their historic rate-hiking campaign, based on Fed Chair Jay Powell’s comments after the Dec. 13 policy meeting, as well as the “dot plot” forecast released on the same day.⁴ But with inflation still high, we don’t expect the Fed will be quick to cut interest rates unless growth slows dramatically. November’s CPI data showed the annual rate of Core inflation (excluding food and energy) continues to fall but still remains well above the Fed’s long-term target of 2%.⁵ Shelter inflation remains a particularly key area of focus, given its large overall weight in the CPI basket — and one that tends to be relatively sticky.

As long as home prices and rents stay high, overall inflation is unlikely to dramatically decline, helping to keep mortgage rates higher for longer than many investors — and prospective homebuyers — would like.

While higher mortgage rates are certainly a headwind for new buyers, most Americans aren’t yet feeling the pinch. Many buyers were able to lock in low mortgage rates before interest rates starting rising, with 14 million U.S. households refinancing their mortgages during the Covid period.⁶ In fact, even though new mortgages are being offered near 8%, the effective interest rate on outstanding mortgages is just 3.6%.⁷

Unlike the housing bubble in 2007, most mortgage holders today are much more qualified borrowers, with higher credit scores, larger down payments, and a larger proportion of fixed-rate loans vs. the riskier floating ones.⁸ Back in 2007, many subprime borrowers faced large balloon payments when the economy was slowing and unemployment was rising, sparking a wave of forced selling that helped pushed housing prices down further. That looks unlikely this time around, with unemployment at just 3.9%.⁹

Instead, a swell of homeowners sitting on below-market-rate mortgages has mostly been felt via a drop in volumes rather than a drop in prices, as has been typical when interest rates rise. Home sales have declined meaningfully: existing home sales have dropped from the 6 million seasonally adjusted rate a year ago to about 4 million now.¹⁰ Outside of the pandemic slowdown, this level of decline in activity is the sharpest in the last two decades.¹¹

There are more signs that suggest the market is stuck: new housing starts (a leading indicator for economic health) have decelerated for both multifamily and single-family housing. Applications for new mortgages are at their most subdued since 1995, and applications for refinancing fell to an all-time low in September, before rebounding in October.¹²

That has resulted in a somewhat unexpected situation: one where home prices have stayed remarkably resilient in the face of rising interest rates, as a lack of supply has outstripped any dent to demand that higher mortgage prices might have caused.

But how long that can last is up for debate, especially given plummeting housing affordability measures. The National Association of Realtor’s Housing Affordability Composite Index is now at its lowest point in its 37-year history, meaning fewer would-be buyers can afford to do so.¹³

Consider: In February 2021 when 30-year mortgage rates were at 3%, a $375,000 mortgage would carry a hypothetical monthly mortgage payment of about $1,600.¹⁴ At the current 8% mortgage rate, that same home would result in a mortgage payment of roughly $2,750. While the payment on the house has gone up over 70%, average hourly earnings have only increased a bit over 12% over the same period.¹⁵

Should existing homeowners need to sell in larger numbers — because of lost jobs, demand for more space, or to relocate to a new city — the increase in supply could (finally) lead to a decline in prices. But for now, the lack of supply and low affordability have locked many buyers out of the market.

Historically, housing has been one of the sectors that leads the rest of the economy into expansion. However, this time looks like it may be different. This post-pandemic expansion saw a rapid and significant rise in interest rates at the very start of the cycle, suggesting that rate-sensitive housing is more likely to be a drag rather than a contributor to growth in the coming year. According to the National Association of Homebuilders, housing normally contributes just over 15% to GDP growth via residential investment and consumption on housing services.

Housing is just one area of the market we’re watching as a gauge of the health of the overall economy, but an important one given its size and importance. It has been said that the impact of higher interest rates is felt with “long and variable lags”, meaning that the full impact of higher mortgage rates may yet be ahead of us.

Caution over the uneasy equilibrium in the housing market — among other factors — leads us to be highly selective in our portfolio allocations heading into next year, as detailed in our 2024 Year Ahead Outlook. In equities, we favor a quality factor tilt that identifies companies with high profitability, low leverage, and consistent earnings over time. In other words, companies that can perform well in a variety of environments and who may be able to weather relatively high interest rates and a slowing economy. Similarly, in fixed income we prefer high quality corporate and government debt to take advantage of higher yields.