Americans aren't buying homes — tax reform didn't help matters

At the current stage of the U.S. economic cycle, lots of things are looking unusual. For instance, wage inflation is barely in sight — even though the U.S. is enjoying its lowest unemployment rate since the late 1960s.

Another particularly puzzling trend is the record level of consumer confidence at a time when the U.S. housing market is showing serious stress. 

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Crucially, by stress, I don’t mean overconfident households are taking on too much debt to buy too many houses, as they did in the run-up to the Great Recession. No, this time, it’s the opposite that’s unusual: Too few Americans are taking on debt and buying too few homes.

And that raises a key question: Is housing the canary in the coal mine signaling that the U.S. is slipping into a new recession? Many of the indicators could be read to say housing is once again leading the way to a downturn, but perhaps all hope isn’t yet lost. 

One thing is for sure. Despite strong overall U.S. economic growth in the past three quarters averaging 3.7 percent, the U.S. housing market itself is now teetering on the brink of a recession.

Sales of previously owned homes have been on a downward trend since peaking in 2016. It’s not that the growth rate slowed. It’s worse; the number of transactions is down 8 percent.

Initially, it appeared the sales decline could be the result of supply constraints rather than weakness in demand. The strong economy and low jobless rate have significantly reduced the number of layoffs, which typically are a source of forced selling as people either move to a new location for a new job or sell because the loss of income makes mortgage payments unaffordable. 

Yet, if the slowdown in sales was supply-related and not a sign of weaker demand, house prices should have increased more rapidly.

Instead, the pace of price growth started to slow at about the same time sales started to weaken, though sales of newly built homes continued to rise for a while. However, since early 2018, new-home sales have started to mirror the downtrend in existing-home sales. 

It has become obvious that this is much more than a lack-of-supply story. To highlight that point, house price growth has slowed more rapidly in the past few months and the number of unsold homes on the market has surged. 

Although new construction hasn’t slowed noticeably yet, that’s because homebuilders are still finishing current projects. But the number of permits for new residential construction has started to fall, signaling we’re heading for a period of weaker construction activity next year.

What has shown no sign of slowing is the pace of job growth in the construction sector, which is still running at near 5 percent annually — more than three times the growth of overall nonfarm payrolls. Job cuts would be the last shoe to drop to show that the U.S. housing market is in recession. 

If insufficient supply of homes for sale isn’t housing’s root problem, what is to blame? The most obvious factor is the increase in mortgage rates to nearly 5 percent for 30-year, fixed-rate loans (the current rate is around 4.8 percent).

A rapid increase often dampens demand for a while before expectations adjust. And mortgage rates more often determine what size house a buyer can afford, but rarely whether to buy or not.

However, this may be one those rare occurrences, thanks to the impact of the Republican tax reform package passed late last year, which has greatly exacerbated the rising mortgage rate shock.

The new limitation on interest payment deductions only to mortgages of up to $750,000 (versus $1 million previously) makes it more costly to buy expensive homes, which are increasingly common in many of the country’s top real estate markets.

In addition, the tax law hiked the standard deduction to $24,000 for married couple filers, meaning many fewer homeowners and buyers will take advantage of the previous benefit they got from itemizing deductions, including the one for mortgage interest payments.

That benefit had reduced the effective mortgage rate by up to 25 percent, or 100 basis points, for a 4-percent mortgage. That creates a significant increase in the cost of carrying a mortgage and could very well shock demand for a while.

However, within the rising mortgage rate story are perhaps seeds of redemption for the housing market. That’s because it’s becoming more possible that the Federal Reserve will hit pause in its current monetary tightening cycle sooner than most observers had expected, until recently.

We think next year the Fed will be looking at an economy that’s gradually losing momentum, in part due to its own actions and in part due to typical late-cycle labor supply constraints. As long as wage growth remains moderate and inflation trends stay close to the bank’s 2-percent target, the Fed has no reason to push rates beyond “neutral.” 

Although this is a fuzzy metric, Fed Chairman Jerome Powell is now indicating that he thinks the central bank is pretty close to that magic level of interest rate equilibrium, at which point the Fed’s policy rate neither encourages nor discourages further economic growth. 

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A cessation in Fed rate hikes, perhaps as soon as summer 2019, would be a tonic for the housing market. And it’s one reason we now expect home sales will pick up again next year. We believe benchmark 10-year Treasury yields — now at a recent low of 2.91 percent — will remain range bound, which should help stabilize mortgage rates. 

Plus, Americans’ incomes are still rising, unemployment is still at multi-decade lows and likely to fall further, and consumer and business confidence remain high.

If the newly forming scenario for Fed rate hikes plays out, the current mortgage rate shock would likely be temporary, not lasting much beyond the next few months. In that case, home sales should stage a rebound in the spring.

The canary is likely just taking a nap, rather than keeling over.

Markus Schomer is the chief economist for PineBridge Investments, a global asset manager.