The Federal Housing Finance Agency reported that mortgage rates on purchases of newly built homes rose by seven basis points over the month of May 2018 to 4.51 percent, marking the seventh consecutive monthly increase. However, information compiled by Freddie Mac suggests that mortgage rates may have taken a breather in June. Despite the two basis points decline in mortgage rates reported by Freddie Mac, they remain near the peak of the recent cycle, 4.59 percent.
Monetary policy continues to exert upward pressure on mortgage rates, but in June, the increase in short-term rates was more than offset by a decline in longer-term rates, likely reflecting financial market’s interpretation of growing trade tensions on economic potential. Mortgage rates were largely flat in June as the decline in longer-term rates was mostly offset by an increase in the mortgage risk premium. For the economy, the increase in short-term rates coupled with the decline in longer-term rates shrank the yield curve further. Although the risk of a recession implied by the bond market may be rising, trends in real economic activity suggest that recessionary risk is falling.
According to Freddie Mac, after rising for seven consecutive months, mortgage rates were about flat over the month, falling by 2 basis points to 4.57 percent. The decline in the 10-year Treasury note rate were largely offset by a rising mortgage risk premium. At the same time, the falling 10-year Treasury note rate more than offset the increase in the 3-month Treasury bill rate. As a result, the term premium, the spread between the 10-year and 3-month Treasury rates shrank by 11 basis points.
One interpretation is that financial markets believe growing international trade tensions will lower the economy’s longer-term performance. While the Fed’s use of its balance sheet has likely impacted the real yield on the 10-Year Treasury note rate, previous analysis suggested that the growth rate of the economy’s potential also determines this real yield. In addition, the two basis point decline in inflation compensation, which has returned as a reasonable signal of inflation expectations, largely reflected a decline in compensation over years 6 through 10, with a one basis point decline in inflation compensation (expectations) over years 1 through 5. An eroding outlook for the longer-term performance of the economy implies that mortgage lending will likely become riskier thus raising the mortgage risk premium.
Another key insight is that actions taken by the Fed to raise interest rates were reflected in the short-term 3-month Treasury bill rate. However, the impact of growing trade tensions more than offset the increasing 3-month Treasury bill rate, and the yield curve (term premium) fell by 11 basis points, suggesting that financial markets may believe that the risk of a future recession has risen.
Recent reports have highlighted the accuracy of the yield curve’s recessionary signals. Other series can also signal an oncoming recession. For example, net tightening of lending standards on commercial and industrial (C&I) loans to larger firms have preceded recessions. This partly reflects the importance of debt financed business investment for job growth. Currently lending standards on C&I loans continue to ease on net.
In addition, changes to the Leading Economic Indicators (LEI), a basket of real data activity, including residential permits, that typically decline prior to a recession’s formal start, has also been historically predictive of a recession. The figure above compares the four-quarter change in the LEI with the yield curve. Currently the two series are moving in opposite directions, suggesting the financial market indicators imply a rising recessionary risk, but real economic activity indicates the risk is declining.
NAHB assesses a wide range of data to assess the likely future of the economy. While trends in the bond market may be interpreted as implying a rising recessionary risk, other data, including real activity are trending in an opposite direction. Most importantly, the activity of our builders, an input in the LEI, are equally important on this topic, as residential production is also a leading indicator of most future recessions.