Housing's Tentative Gains

If anything could sabotage recovery prospects it would be another swoon in housing. That's why the recent rise in long-term interest rates has raised concerns among investors. Yields on 10-year Treasury securities have increased to 3.6%, from 2.6% three months ago, and the average 30-year mortgage rate is up 0.6 percentage points, to 5.4%. A new downshift in home demand would put further pressure on home prices, leading to more bank writedowns of mortgage securities and more erosion of bank capital. Clearly, that's not something the Federal Reserve would like to see.

As the Fed sat down for its two-day meeting on June 23-24, it faced a dilemma. Rates are rising partly because improving prospects for recovery are focusing attention on when the central bank will begin to tighten policy. Any effort to push long rates lower by further boosting purchases of Treasury and mortgage securities could backfire. Investors are getting uneasy about the potential inflation consequences of Fed programs that already have pumped more than $1 trillion into the system. Cranking out even more funds could heighten those concerns and end up lifting rates.

For now, policymakers are trying to finesse the problem with their words. As generally expected, the Fed, in its post-meeting statement, sounded a bit more upbeat about the economy, but it emphasized that any policy tightening was still a long way off. It did not add to its existing commitments to purchase various securities, but it did retain some flexibility in those programs, suggesting it would increase its buying if higher rates threatened a recovery.

It seems especially unlikely that the Fed would allow mortgage rates to rise to levels that would thwart the recent stabilization in housing sales and starts. In May, sales of both new and existing homes continued to stabilize, helping to reduce inventories, while starts of single-family homes jumped sharply. The rate rise creates at least a small risk for housing, but any impact will not show up until the June data.

Housing affordability is sure to fall, but it should remain at levels not seen since the 1970s. Affordability had soared to record levels earlier this year, as mortgage rates dropped to 4.8% amid falling home prices. Still, although rates are up, they have declined a bit in recent days and remain low by historical standards. Plus, rising consumer confidence, a diminution in job losses, and improving financial conditions should add support.

Recent comments by policymakers suggest the Fed is more concerned with why long rates have risen than with their higher level. Some key officials think higher Treasury yields reflect waning fears of deflation and signs that the recession is bottoming out. If so, that's a welcome sign the economy can handle a nudge-up in rates. It shows investors are regaining their appetite for risk: While Treasury yields have risen, yields on corporate bonds have declined. Coming against weaker demand for Treasuries, the onslaught of supply as Washington finances its deficits may be adding to the downward pressure on bond prices and the upward tilt to yields.

Few Fed officials believe inflation fears justify the rate rise. A key market-based measure of expected inflation, based on Treasury Inflation-Protected Securities and followed by the Fed, stood at 2.79% on June 17. That rate is slightly elevated from three months ago but remains comfortably within the range of the past five years. Most economists believe that with so much slack in the U.S. and global economies, the Fed will have plenty of time to sop up its excess funds before they kindle inflation.

But economists don't run the bond market. The fear of future inflation and the timing of Fed tightening are key issues in market thinking right now. Eventually, policymakers must convince Wall Street that inflation and interest rates will stay low enough to support a lasting recovery. Until then, investors will remain jumpy.

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