Interest rates are finally rising, and as we observed this morning, the 10Y – now above 2.60% and the highest since last March…
… is now on the cusp of breaking above the 2.63% level which Jeff Gundlach said last week is where stocks will be negatively impacted.
And while the financial sector is poised to benefit from this increase, although not if the curve flattens and eventually inverts, something which would unleash havoc among the banks, there are many parts of the US economy that will be unequivocally and negatively impacted from the rise in interest rates. Among them are housing, business investment and, of course, consumer spending: with credit card already at record highs, increase in the APR will crush America’s purchasing power.
But which one will be hurt the most? That’s the question Goldman’s economist team set to answer when it asked overnight “which sector is likely to experience the largest drag from higher rates.” Goldman then analyzed the Fed’s FRB/US model as well the slowdown in housing activity following the rate spikes in mid-2013 and late-2016, and find that “housing activity is several times more rate-sensitive than business investment and consumer spending.”
Clearly, this is a problem for the US economy, where the bulk of the middle-class wealth is found not in the stock market, but in the biggest investment most Americans will make over their lifetime – their house. And with rates expected to keep rising, it’s only going to get worse.
As Goldman’s Daan Struyven writes:
Over the past four months, the 10-year Treasury yield has risen about 50 basis points (bp) to 2.53%. We expect long-term rates to rise by an additional 100bp in the next two years as the Fed continues to tighten policy once-per-quarter and the term premium rises (Exhibit 1).
Well, for the sake of stocks, Goldman’s rate forecast better be wrong as it implies a sharp slide across all rate-dependent risk assets. But what about all those other, far more critical for most people, sectors of the economy?
Here, Goldman estimates the impact of higher interest rates on the major components of aggregate demand using the Fed’s FRB/US model. FRB/US implies that residential fixed investment is several times more rate-sensitive than nonresidential fixed investment and consumer spending. The estimates in Exhibit 2 imply a peak 5% decline in the level of residential investment per 100bp increase in the funds rate vs. peak declines of 2% and 0.4% for business capex and consumer spending respectively.
Notably, if predictably, housing activity stands out even more in its sensitivity to long-term rate shocks as people’s long-term inflation expectations are shifted substantiall more.
In quantiative terms, the Fed’s FRB/US model implies a roughly 5% decline in the level of residential investment per 100bp increase in long-run rates vs. peak declines of about 1% and 0.2% for business capex and consumer spending respectively. This is shown in the chart below.
There is more recent evidence to confirm that rising rates will likely crush housing: In the four months following Bernanke’s “tapering” testimony in May 2013 and President Trump’s election in November 2016, mortgage rates rose by almost 100bp and 75bp respectively. In the subsequent nine months, Goldman’s housing Current Activity Indicator (CAI) decelerated in both instances by about 2.5pp relative to the non-housing CAI.
But wait there’s more: in addition to the housing sector’s legacy sensitivity to rising rates, Goldman notes that when looking ahead, it finds two reasons why the rate sensitivity of housing activity could rise somewhat further. Thank tax reform:
- First, by capping and lowering the utilization of mortgage interest deduction (MID), tax reform would likely limit the cushioning that this deduction provides against interest rate increases. For example, while a 100bp increase in the interest rate on a $300k potential new mortgage would raise the annual after-tax interest payment by $2.1k if the MID is deducted against a 30% rate, this increase amounts to $3k for a non-deducting household.
- Second, breaking down home values into land and building structures, an ongoing increase in the share attributable to land—which is basically a perpetuity— will also likely continue to raise the rate sensitivity of housing. Exhibit 4 shows that the estimated land share of property values has risen by around 10pp since 1975, perhaps reflecting tighter land use regulations. While an increase in interest rates should lower the value of land, it should not directly affect the construction costs of new homes, and it should have a smaller effect on the structures value of existing homes. In a simple Gordon growth model, an increase in the interest rate from 4% to 5% lowers the values of land and structures by about 20% and 10% respectively (assuming 2% annual depreciation and zero growth).
Bottom line: higher interest rates are likely to weigh the most on demand in the housing sector in the coming years. In the context of Goldman’s forecast for a 100bp increase in long-run rates, it implies a 5-6% drag on residential fixed investment spread over the next few years. This also means a sharp drop in property and real estate values, and a substantial hit to the middle-class wealth effect.
We wonder how long it will take the algos to figure out that the tax cut they are cheering on the corporate side are planting the seeds of the economy’s next recession once interest rates finally break out above the 2.60% critical resistance zone.