Freddie's Economic Revisions Optimistic for Housing

Freddie Mac's economists have revised many of their earlier estimates for the 2015 U.S. economy.  In terms of overall economic growth the revisions are not positive as they see a slowing of "the torrid pace in the third quarter of 2014," but their new projections are good news for housing, with lower rates and a higher level of mortgage originations.

Leonard Kiefer, Freddie Mac's Deputy Chief Economist, said in February's edition of the U.S. Economic & Housing Outlook, that there is considerable tension in interest rates.  While it is expected that the Federal Reserve will begin raising short-term rates this year, the prevailing theory is between mid-year and the third quarter, long term rates have fallen from their peaks in 2014.  Ten-year Treasuries have declined by about ½ percentage point since October, twice reaching as low as 1.68 percent, the lowest rate since 2012.

Since the most recent low on February 2 strong employment figures have caused rates to bounce back but they remain below levels at the beginning of the year,  Even if the Fed raises short-term rates sooner than anticipated, it is unlikely, Kiefer says, to lead to a dramatic rise in their long-term counterparts. 

Even as there has been a recent increase in short-term rates in anticipation of Fed action, long term rates continue to decline, resulting in a flattening of the yield curve.  Analysts often interpret this phenomenon as indicative of a weakening economy and a possible warning of an approaching recession.

Kiefer said there are two theories for the recent lowering of long-term rates.  One is that these rates are based upon expectations for short-term rates and factors in a term premium to compensate for risk.  Under this theory the recent decline is the result of lowered expectations for short term rates and, if investors accept that the economy is weakening they will accept lower premiums to compensate for risk.

The competing theory is that short-term and long-term securities are not close substitutes and thus movements in the former have limited effects on the path of the latter which are instead driven primarily by supply and demand dynamics within the securities markets.  "Thus it is supply (issuance of debt less retired securities and central bank purchases) and demand (domestic saving and foreign capital flows) for long-term bonds that drive long-term interest rate movements. The sharp decline in the budget deficit since 2009 has reduced net Treasury issuance, despite a systematic effort by Treasury to extend the average weighted maturity of its debt portfolio. The result is a reduced incremental supply of long-dated securities."

At the same time, events in the global arena such as reduced interest rates in Europe and Japan and growing concerns over global growth have driven a flight to safety and into purchases of long-term U.S. securities.  The latest data from November, portrayed in the chart below, shows the recent surge in net foreign buying of these securities, especially Treasury bonds and notes.  Recent trends support earlier research showing that net foreign purchases of long-term securities have a large impact on long-term rates.

Freddie Mac's economists adhere to the theory that the recent declines in long-term rates are a function of reduced availability of long-term Treasuries and increased foreign demand rather than fears of a weakening U.S. economy.  Furthermore, they expect recent trends in foreign buying activity to continue which means continued downward pressure on long-term interest rates.  Even if the Fed does begin to raise short-term rates later this year, they don't expect to see long term rates increase much.  They do expect that there will be considerable volatility in rates in the weeks leading up to and after the Fed moves.

That said, Freddie Mac is revising its projections for many of the major economic indicators from those it made last month.  Overall economic growth for the first quarter of 2015 is now put at 2.5 percent rather than 3.0 percent and 2015's annual growth will be 2.9 percent, 0.1 percent below earlier predictions.

But for the 30-year fixed rate mortgage, change is good.  The company estimates that the average rate for 2015 will be 3.9 percent rather than the 4.2 percent it projected last month.  Average rates in 2016 will rise to 4.8 percent.

Further, lower rates along with an improving jobs picture continue to provide a brighter outlook for housing activity this year than last.  Freddie Mac holds to its prior forecasts of 5.6 million in home sales this year and 1.18 million residential construction starts.  They have raised their estimate of home price growth from January's 3.5 percent to 3.9 percent in 2015.  The projections for higher home prices and lower rates have led them to push estimates for 2015 one-to-four family mortgage originations up from $1.2 trillion last month to $1.3 trillion, easing back to $1.275 trillion in 2016.  Refinancing will also take a larger share of overall mortgage business, rising is the revisions from 35 to 40 percent.