Amid Unexpectedly Positive Economic Conditions, High Interest Rates Hold Back Mortgage Originations

iEmergent Mortgage Opportunity Forecast Update - August 2023

iEmergent recently released our latest forecast update. The good news is that the overall American economy continues to demonstrate remarkable strength and resilience in many areas despite significant rises in interest rates. The bad news is that, for the mortgage origination market, that strength is keeping long-term interest rates high, exacerbating affordability for potential homebuyers, and strangling refinance incentives. That has caused us to lower both our purchase and refinance outlooks for 2023 and 2024.

Despite aggressive Federal Reserve tightening, the economy is staying stubbornly healthy.

• Inflation—the reason for tightening: Inflation began to accelerate in early 2021 due to supply/demand imbalances from the COVID pandemic and associated stimulus measures, as well as disruptions from the Russia-Ukraine war. However, for the last year, it has been falling nicely. The core PCE price index (personal consumption expenditures excluding food and energy) is the main inflation index the Fed follows, and its growth rate has fallen from 6.0% in Q1/2022 to 3.8% in the latest (advance) report for Q2/2023. Other inflation measures show even more dramatic improvement. Headline CPI inflation has declined from its 9.1% 2022 peak to 3.2% in July.
• Interest rates: Since March 2022, the Fed has raised the Fed funds target rate eleven times to an effective range of 5.25-5.50%, and it will likely go further. The U.S. hasn’t experienced rate hikes this far and this fast since the early 1980s. Long-term rates also moved up sharply, but due to the financial market’s pessimistic outlook, not as much as short-term rates. Thus, for over a year now, we’ve experienced a yield curve inversion, where short-term rates exceed long-term rates. Historically, this is a nearly infallible indicator of impending recession within a year; yet so far, no recession looms.
  
• Real GDP: Despite Fed tightening and several negative indicators (falling consumer and small business sentiment, tightening bank lending standards, manufacturing declines), real GDP growth remains surprisingly robust. First quarter growth was up 1.8% year over year, and in the advance report for Q2, annualized growth improved to 2.6%.
  
• Employment: The labor market is still very strong. The July unemployment rate was 3.5%, back to what it was before COVID hit, which was the lowest since the 1960s. And while the Kansas City Fed’s Labor Market Conditions Index (LCMI)¹, a composite index of employment measures, is on a declining trend since last August, it is still at a healthy level compared to previous expansions, and it showed a strong improvement in July.
• Housing: A resurgence in home price appreciation and home building points to confidence by both homebuyers and home builders. Although we expect home price increases to soften soon due to the affordability squeeze, it still indicates unexpectedly strong housing demand for now, even though sales volume is still slow.

These positive recent developments have turned around the pessimism of 2022 and early 2023. The Fed may indeed be able to achieve the difficult feat of a “soft landing” in which it is able to stamp out inflation by slowing the economy without causing too much economic pain (i.e., unemployment). This is something many economists considered unlikely just a few months ago.

However, for the mortgage origination business, this is a miserable time. After its staggering decline in 2022, this year’s market continues shaping up to be even worse. The recent positive moves in the economic outlook have caused long-term rates to drift up. In the week ending August 24, the average 30-year fixed mortgage rate hit 7.23%, the highest since 2000. For refinances, the market is on life support. Inside Mortgage Finance, an industry newsletter, estimates the first two quarters of 2023 refinance production at only $101 billion, less than half as much as the first two quarters of 2018, which was the slowest refinance year in the last decade. For purchases, higher mortgage rates coupled with higher home prices mean unaffordability is also hitting new records, which will constrain home sales.

Despite the recent positive economic news, we continue to believe an economic slowdown is coming; we’ve just pushed out its arrival time from late this year to mid-2024. We also believe that rising home prices are not sustainable at the current level of housing affordability. We expect home sales volumes to continue at their current weak pace or even lower for the rest of this year, eventually leading to softening home prices going into next year. In 2024, lower long-term interest rates and softening home prices should lead to slightly higher mortgage originations levels.

¹ The Kansas City Federal Reserve Bank Labor Market Conditions index (LMCI) is a composite index of 24 different employment measures including full- and part-time employment rates, initial claims for unemployment insurance, average hourly earnings, JOLTS (job opportunity layoff and turn-over survey) hire and fire rates, labor force participation rate, and more.