This one shows how 30y mortgage rates have trended down, and US national home prices trended up, since the late 1980s. Note that this chart shows the index value of home prices, and not the change in the index value, as depicted in the chart from Part 1.

These opposite trends, together with the strongly entrenched interest rate fallacy, has led to many people screaming that lower rates are causing housing bubbles.

This may have been true prior to the Great Financial Crisis (GFC), when housing credit availability was much higher (remember banks and subprime lending?).

But, beware the trap of mistaking correlation with causation!

Based on what we now know about the interest rate fallacy and the Housing Credit Availability Index, our post GFC reality is clearly more complicated than what this chart implies.

Yes, mortgage rates have undoubtedly fallen over the past few decades together with US Treasury yields. However, this does not mean that higher rates will cause national house prices to fall in a dramatic fashion.

Why not? 

Firstly because, post GFC, lower mortgage rates have only benefited a small subsection of the overall home buying population – those who are very creditworthy. As such, higher rates won’t be the main factor in popping the bubble of today’s high home prices.

This is due to the fact that the ones doing all the borrowing, buying, and selling are some of the most creditworthy folks in the country. It will take a much larger interest rate shock to drive this particular demographic into mass defaults.

Secondly, and arguably more importantly, real estate is its own market.

What does this mean?

Simply that the financial media likes to point towards a single external factor as causing a particular market to rise and fall, when it’s really the internal factors that matter more.

That is, the supply and demand dynamic in the particular market.

Good examples of such thinking are plentiful, from low interest rates being blamed for high equity prices, to QE and almost every market.

At the end of the day, most, if not all of these examples represent the conflation of correlation and causation. A deeper understanding of these markets and how the external factor supposedly affects them will reveal this.

Now, the same thing is happening in US real estate.

As hysteria over Fed hawkishness mounts, even with uncertainty over the second order effects of war in Ukraine, folks are forgetting that what really drives prices in the housing market is demand running ahead of supply.

For whatever reason, since the onset of the pandemic, folks who are able to get banks to finance them have been piling into the housing market.

No complicated analysis is needed to see this, rising home prices tell the story succinctly. Demand is running ahead of supply.

Until this changes in a significant way, the housing market will remain bullish, regardless of what interest rates are doing.

A simple way to see the truth of this is again by understanding the interest rate fallacy. As explained in Part 3, banks make more mortgages when demand is high, driving mortgage rates higher.

This implies that folks who are purchasing homes for investment or speculative purposes think that the rate of return they can earn is higher than the mortgage rate they have to pay.

Put another way, would you borrow at 4% to purchase a house that you intend to flip if you think that you can only sell it for a 3% return?

Obviously not!

You would only be willing to take out a mortgage at 4% if you think that you can get a return greater than 4%.

All of this is not to say that interest rates have no effect on house prices – of course they do. 

How much potential homeowners have to pay to finance their purchase is one of the factors affecting their final decision. If mortgage rates rise to the point where they exceed buyers’ expectations of future returns, the market will obviously be negatively affected (at least for a while).

Ultimately, it is important to remember that real estate is its own market.

Interest rates are but one of the many factors that affect the supply and demand dynamic within it, and should not be seen as the only, or main, factor driving prices.

Thinking otherwise is dangerously reductive! 

To be continued…