The Latest Bubble to Pop:
Mortgage Rates and Their Butterfly Effect on the Economy
Frank O. Trotter

Unless you bought a house in the last year, you probably didn’t even notice.

Mortgage interest rates, which had been declining since 1981, have spiked. After touching a record-low 3.3% in 2013, a 30-year, fixed-rate mortgage costs about 4.3% today.

That 30% increase in just a few months sounds huge. But by zooming out a bit, we can see the full picture: at 4.3%, the rate on a 30-year mortgage remains just half of its long-term average of 8.5%:

From this view, the spike looks more like the beginning of a return to normalcy than a worrisome signal. So, it’s no big deal, right?

Not exactly. As today’s guest author and seasoned banking executive Frank Trotter will explain, even small changes in mortgage rates reverberate to all corners of the economy. When your mortgage payment rises, your discretionary income drops, so you both spend and save less. Follow that daisy chain to its logical end and you’ll find that, to varying degrees, all businesses are at the mercy of mortgage rates—whether they know it or not.

And while it’s true that the recent mortgage rate spike is small in a historical context, remember that it marks the reversal of a 32-year downtrend. In other words, it’s a game changer.

Before I pass it to Frank, let me first mention that we’ve chosen San Antonio, Texas as the location for our next Casey Research Summit to be held from September 19-21.

We’re still finalizing the agenda and faculty list, but registration is open—you can save up to $400 by signing up now and taking advantage of our early-bird pricing. Click here for more info and to register.

Dan Steinhart
Managing Editor of The Casey Report

We’ve fallen and can’t quite get up!

Sometimes the unending stream of economic numbers starts to look like the dripping green images in The Matrix.

We attempt to be Cypher, “conceptualizing” the image through the digits: “All I see now is blonde, brunette, redhead.” But our collective attempts at econometric modeling on the fly often result in a muddled, rather than precise, picture.

Still, there are moments when the world clarifies before our eyes. August 1971. October 1979. September 2001. September 2008.

And then there was May and June 2013.

Maybe you’re thinking, Um, Greece? Syria? Budget negotiations? Debt ceiling debates? Something in Congress?

Nope.

Right now and for the past several years, interest rates have been at a 50-year low. Many people focus on the short-term yields. But the 10-year Treasury Note remains below the red line on my chart that illustrates rates all the way back to 1960.

It’s all part of the fifth branch of government’s (Executive, Legislative, Judicial, Regulatory, and Monetary) tactic to “lower real interest rates.” Through this tool, the Fed seeks to boost inflation expectations, lower the US dollar, and boost asset prices. With fiscal and regulatory policy already running at full speed, the Fed’s suppression of interest rates appears to be its last hope to make the water of the economy run uphill.

And, of course, what happens when interest rates are relatively low? People and corporations borrow money or refinance old debt. We saw this occur in Europe after the introduction of the euro and through the 2000s. Pretty much every country borrowed at a cost very close to that of the lead country, Germany.

That is, until lenders realized that Portugal, Italy, Greece, Spain, and Ireland really weren’t the same credit risk as Germany, and their rates soared. Turns out capacity to repay is actually meaningful.

Here at home, with rates held artificially low, we have had the mother of all refinancing booms. Mortgages issued for refinancing as a percent of total mortgages peaked at almost 76% in late 2012, according to the Mortgage Bankers Association.

Refinancing a mortgage can be a great thing for the borrower. Running through the math, payments on a $200,000 loan financed in the early 2000s at 8% would be about $1,500. Refinance that mortgage at 4%, as many borrowers did, and the payments drop 30% to about $1,000.

Voilà, the consumer will save an extra $6,000 per year. Or, more likely, since Americans are not inclined to save, will spend an extra $6,000 per year. That’s a win-win from the perspective of policy makers, as that $6,000 will add to the consumption component of GDP in each year going forward.

Of course, on the other side of the transaction, lenders receive $6,000 less per year. If their inclination to save is the same as consumers’, the net impact on the economy is zero. However, somewhat by definition, lenders are savers. So interest rate suppression is likely to produce a decrease in net worth.

Of course, if you are in one of the Five Branches and are scrambling to “fix” the economy, you would have hoped that instead of a refinancing boom old borrowers would buy new houses. Checking our math again, if our friendly household had decided to maintain its $1,500 monthly payment, it would now be able to borrow about $310,000 at the new 4% rate.

That would mean the homeowner could bid on a new home at a much higher price and help stabilize home values. As we’ve seen, home prices have climbed by over 10% in most markets over the past year. So it would appear that something like this has been happening.

But actually, as moneynews.com reported, it turns out that “all-cash purchases, dominated by investors, are surging . . . Deals in cash accounted for more than 43 percent of U.S. residential sales in February, up from 20 percent a year earlier, with the most in Florida, New York and Nevada, according to data firm RealtyTrac.”

In this case, “investors” is code for speculators—the first participants in any market. After a fall—or in this case, free-fall—in an asset class, speculators are the initial participants in price discovery. Some are too early and lose money when values continue to fall below their entry point. But as the numbers firm up, they make gains when no one else is willing to play. Longtime subscribers to Casey Research are familiar with this blood-in-the-streets tactic.

Enter May and June 2013

After the famous “head-fake” comments by Fed Chairman Bernanke on tapering, yields on the 10-Year US Treasury Note rose from about 1.60% to a touch over 2.60%, roughly where they stand today. We contend that this remains below the market-clearing level if the Fed did not intervene.

Still, the move was enough to change the world.

In the first quarter of 2014, the Mortgage Bankers Association reported that about $266 billion in total loans were written—about half the amount undertaken one year before. Final numbers aren’t available yet, but based on Wells Fargo’s comments, the proportion of refinancing dropped to 34% from 69%.

In essence, the refinancing game is nearly over.

Just looking at the mortgage side of life, this means that the increase of households’ retained cash flow is unlikely to improve further. For many of the large lenders, it also means a reduction in workforce—a significant one, in many cases—which will impact employment figures and possibly further recovery.

A final note in this saga pertains to household leverage. Common wisdom seems to hold that US households have deleveraged since the mid-2000s crash, and therefore economic risk levels are lower. Unfortunately, that’s not the case.

In 2008, total household liabilities stood around $14.2 trillion. At the end of 2013, they were $13.8 trillion—a paltry 2.8% decline. Yes, a lot of that debt is now cheaper for people who refinanced. But so much for getting our house in order.

Maybe there is a little light at the end of the tunnel. People purchase houses, after all, not based on cold economic facts but with desire and hope. On Friday, my longtime friend and colleague Chuck Butler stopped by my desk. “I was driving around with Duane last weekend,” he said, “and we saw something we haven’t seen in years. A brand-new, stand-alone housing development.”

That is certainly a ray of hope. But I wonder if—like the flowers that started to bloom three weeks ago here in our little river town, only to be bombed to shreds by back-to-back hail storms—this builder may be out a little too far over its skis.

Putting this all together, I wonder if the US economy will keep puttering along, even in low gear, now that slightly higher rates are here. Housing is about 15% of GDP, so any reduction in activity will be reflected in the Q1 GDP numbers, and possibly in downward adjustments to last year’s numbers.

Just to underline that point, Chuck Butler over at the Daily Pfennig notes that John Williams of Shadow Stats is calling for a possible negative GDP number in Q1.

Sitting in an industry conference a couple weeks ago, the meeting kicked off with three major-league economists from prominent firms. All three said, in essence, that the US economy was on the brink of a solid recovery and that US assets—especially equities—might do extremely well over the next 5-10 years.

I like to look at the numbers to see if they confirm any economic arguments I hear. For example, “Russia is selling all its US Treasuries” doesn’t seem to make sense when the 10-Year Treasury rate remains constant.

In this case, the US stock market has in fact been on an upswing for over five years. We hear many advisors say not to stand in front of the train—jump on board for the ride. And perhaps there is some reason to do so—if you keep a lookout for any broken rails ahead.

At the same time, the potential for slower growth described here, due to even slightly higher rates, gives me pause. A performing equity market isn’t necessarily an indicator of health—witness Argentina as the best-performing market index through most of 2013, amid a genuine mess of an economy.

But watching currencies and metals, we see a different story. So far in 2014, the dollar has only performed better than low-quality currencies that few would care to own. On the other hand, currencies that have gained vs. the USD carry stronger pedigrees. And even after leveling off a bit recently, gold and other metals have had a good year to date.

Parsing all these numbers suggests that the US isn’t out of the woods. Those calling for a sharply higher USD and a continuation of poor performance in the emerging and developing markets may be reading the wrong pigeon’s entrails.

Mr. Trotter has served as an Executive Vice President of EverBank Financial Corp since 2009 and as an Executive Vice President of EverBank since 2002. Additionally, he serves as President of EverBank Direct, EverBank's consumer direct banking division and is a founding partner of EverBank.com, a national branchless bank that was acquired by the current EverBank in 2002. Mr. Trotter previously served as Senior Vice President and Managing Director of Mercantile Bank Capital Markets and Director of the International Markets Division at Mark Twain Bank, where he created the WorldCurrency® family of deposits and directed the global launch of eCashSM. Mr. Trotter has over 20 years experience in the banking industry and received a B.A. from St. Olaf College and an M.B.A. from Washington University.