Fannie Mae made a few modest changes to its economic
projections this month as consumer spending in January was above expectations
and interest rates rose. The company’s Economic and Strategic Research (ESR)
Group expects the growth in GDP in 2021 to be 6.6 percent rather than its prior
6.7 percent forecast and upgrades 2022 to 3.0 percent from 2.8 percent. Compared to last month’s forecast, they also expect
a modestly stronger consumer recovery, but a more drawn-out expansion of
government expenditures and a modestly slower pace of private investment
A downside risk to the forecast is the possibility of a more resistant virus
variant emerging, leaving the future path of the virus a near-term risk. The greatest
uncertainty, however, is how fast social distancing restricted activities recover.
If businesses and consumers are reluctant to resume pre-pandemic activities,
the expected strong 2nd and 3rd quarter growth may not
materialize. On the upside, household savings are extremely high; checking
accounts alone held $3.2 trillion in Q4 2020, $2 trillion more than the pre-COVID
baseline. If consumers spend down these balances as well as their stimulus
check, consumer spending might be greater than Fannie Mae’s robust projections.
The company does not think rising interest rates to date, are a major
concern and modest additional increases would likely be a reflection of a
healthy, recovering economy. They do, however, see that, if inflation expectations
continue to accelerate that could lead to a greater rise in rates. While the
absolute level is still modest, market-based measures of inflation
expectations, such as the 5-year TIPS/Treasury spread, have moved up
considerably in recent months, indicating growing investor apprehension over
The economists call the rise in long
term interest rates probably the most noteworthy development over the last
month. The 10-year Treasury rate as they went to press was 1.63 percent, up
from 1.09 percent at the start of February. The level remains modest, the
10-year Treasury rate averaged 2.32 percent from 2011 to 2019, but the increase
was rapid. Even if inflation expectations remain subdued, with the forecast for
nominal GDP growth, it is entirely plausible that the 10-year Treasury rate
could reach the 2.5 to 3.0 percent range by the end of 2022.
They do not think the pace of
increases will continue, however, and that rates will drift only modestly
higher over the remainder of this year, and that the Fed will keep its
accommodative policy until inflation clearly exceeds its 2.0-percent target for
a substantial period.
The 30-year fixed mortgage rate will
probably increase less rapidly than the 10-year Treasury note in the short-run.
The roughly 55 basis point increase in the 10-year Treasury since the beginning
of February, corresponded with about a 30-basis point increase in the mortgage
rate. Over the past year, a surge in originations led lenders to build out
operating capacity. Therefore, in the short run originators will probably absorb
some of the increase in funding costs to maintain production volumes.
With a higher forecast for mortgage rates, Fannie Mae has modestly lowered its
homes sales forecast for 2021 from a 6.9 increase from 2020 last month to a 6.2
percent, but stress that rates will not be the primary driver of the slowdown.
Rather it will be due to waning timing effects of homebuyers’ delaying or
moving forward purchases due to COVID-19 and an extremely tight inventories limiting
transactions. An ample number of homebuyers should be able to absorb modestly
higher mortgage rates near term and so an upwardly drifting rate will have only
a minimal impact on the sales. The downward revisions in the forecast for
mortgage originations is more severe because refinancing activity is highly
rate sensitive. Total originations in 2021 have been changed to $3.9 trillion
from $4.1 trillion and the 2022 projections have been downgraded from $3.2
trillion to $2.9 trillion.
However, if rates move up more
aggressively than the baseline forecast, the economists invite a comparison
with 2018, the last time rates underwent a period of significant increases. The
30-year mortgage rate rose a little more than 100 basis points in a 14-month
period. On a quarterly basis, total home sales fell by about 8 percent
peak-to-trough, despite employment and incomes continuing to expand. If
something similar were to occur over the next year, there are reasons to
believe that the drag on sales would be considerably smaller.
First, “lock in” effect
will be weaker. When rates hit 4.9 percent in late 2018, a seven year high, most potential repeat buyers had likely
purchased homes or refinanced their notes at rates lower than the going market
rate, creating a disincentive to move to a new home. In contrast, even if
mortgage rates today rise to 4.0 percent that would still be a lower rate than
prevailed over most of the past decade. Most homebuyers do not move within a
year or two of purchasing or within a year of refinancing. Thus, the lock-in
effect should be comparatively muted for the next couple of years if rates do
not move beyond roughly 4 percent.
Second, rates are still historically low, keeping mortgage
payments comparatively affordable relative to income and well below the 2018
peak even as home prices have rapidly appreciated. To reach the 2018 payment/income
ratio today, the 30-year rate would have to be about 3.9 percent.
More homebuyers are likely able to absorb higher
payments. Given the high savings rate, credit card balances that have been paid
down by $118 billion over the past year, and stimulus payments, the potential
buyer pool has lower back-end debt to income (DTI) ratios, stronger credit
scores, and a greater ability to make larger down payments compared to 2018.
The current limited supply of homes for sale is likely
holding back transactions with many potential buyers unable to find a suitable
home or being outbid. Even if some buyers drop out of the market because of
rising rates, there is probably an ample “reserve” of buyers to fill their
place in the near-term. Appreciation will likely soften as bidding wars ease,
but the effect on transactions would be limited. Additionally, homebuilders are
currently struggling to keep up with demand, suggesting they would continue a
brisk construction pace even if traffic cooled.
Taking these factors into account and with the future
path of interest rates uncertain, one scenario employed by the ESR group was for
mortgage rates (relative to the baseline) to rise an additional 50 basis points
by the end of 2021 and 85 basis points by the end of 2022. With other relevant
factors unchanged, this translates to a 30-year fixed mortgage rate of 3.7
percent and 4.3 percent, respectively, a range more typical of the pre-COVID
period previously discussed.
This resulted in only a modest reduction in home sales
relative to the baseline of about 1.0 to 2.0 percent in 2021. Declines in 2022
were somewhat larger at 4.0 to 5.0 percent (again relative to baseline), as
some of the factors mentioned above diminish, but the softening is still modest
compared to the past.
Consistent with this view that home
sales will be only modestly affected by recent rate increases, the forecast for
purchase mortgage origination volume is up 13 percent from 2020, to $1.8
trillion. This is driven by expectations for higher full-year home sales this
year compared to last, as well as continued price appreciation. However, Fannie
Mae has revised refinancing estimates down by 6 percent from its February forecast
to a yearly volume of $2.1 trillion. Application activity suggests refinance
volumes will stay elevated in the first half of 2021 before retreating over the
second half as the mortgage rate is now projected to rise faster than previously
thought. The forecast for 2022 refinance volume was also revised downward by
about $240 billion to $1.1 trillion.
While higher rates led to a downward revision, even at the current 3.1 percent
rate, Fannie Mae estimates that 48 percent of all outstanding mortgage balances
have at least a half percentage point incentive to refinance. However, returning
to the alternate scenario where the 30-year fixed rate is 3.7 percent by
year-end 2021 and 4.3 percent by the end of 2022, refinance originations would probably
fall by about 14 percent relative to the baseline forecast this year, and about
44 percent lower in 2022.