Credit Musings: October 11, 2022

Oct 11, 2022

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Public Trust Credit Team

U.S. housing market set for decline after pandemic boom comes to an abrupt halt.

In a swift reversal of policy, rapidly rising interest rates in the U.S. are primed to reverse the course of the country’s housing market. Home prices had been skyrocketing since the COVID-19 pandemic, with the Case-Shiller U.S. Home Price Index continuously blowing past all-time-highs annually since 2016, with year-over-year growth above 20% since the start of 2021. However, the Federal Reserve’s aggressive interest rate hikes have rapidly pushed mortgage rates from near-zero earlier in the summer to 6.66% for a 30-year fixed, the highest level since 2008. The effect this has on the housing market is already beginning to be seen, with refinancing applications down 80% and new mortgage applications dropping 29%. The combination of rising rates, recession, hyperinflation, and lingering post-pandemic effects are creating an incredibly unfriendly environment for potential homebuyers, and the industry is bracing for the fallout.

Realtors, mortgage brokerage firms, appraisers, and construction groups claim that revenues have declined by as much as 80% since the Fed began raising rates. While this is a disturbing statistic in any industry, real-estate is particularly vulnerable to this downturn due to the frenzied growth over the past two years. During the pandemic boom, a record 1.5 million Americans became real estate agents to take advantage of flexible hours and skyrocketing profits; however, many of their jobs may be in jeopardy as the market dries up. Linda McCoy, the board president for the National Association for Mortgage Brokers, said that the industry has gone “from feast to famine, from everybody buying to turtle slow” since the Fed started raising rates, and that “the way these rates have risen so fast is almost catastrophic to the industry.”

The housing market is a centerpiece of the broader U.S. economy, and this downturn will have rippling economic effects outside of the industry itself. Property values are incredibly important to local governments’ tax revenues and are certain to impact the credit outlook of many state and local municipal bond issuers. Additionally, the housing market is a key component of GDP growth, and a decline in housing prices will lead to a decline in construction spending, which further slows the already idling economy.

The International Monetary Fund (IMF) meetings with the World Bank are expected to bring bleak news.

This week, the IMF is holding meetings in Washington with the World Bank to discuss global economic output. Rates have continued to climb in 2022 to harness in hyperinflation and the aftermath may be dourer than initially expected. In addition to rising rates, the Russia / Ukraine conflict and China’s slowdown caused from extended COVID-19 protocols have added fuel to the fire and are projected to stunt global output in the near-term. As the litany of global economic indicators continue to produce less than ideal news, forecasts extending out into 2023 have been lowered to match what appears to be the new reality. The global economy expanded 6% in 2021, highlighting the overall expansion after the world put itself on pause in 2020. However, the IMF is showing the world economy to expand 3.2% in 2022, and further declining to 2.7% in 2023. Most notably, China is projecting a growth of 3.2% in 2022, a reduction from its world-leading figure of 8.1% in 2021. An unusual hurdle the world is now facing trying to mitigate inflation is just how much monetary contraction will impact global production. Risks include U.S. dollar appreciation, elevated energy, food prices, reduced natural gas, and a potential central banking issues in China caused by a real estate collapse. With world banks, country interlinkages, and connectivity more powerful than ever, it remains extremely difficult to accurately predict how fixing one problem in one country may exacerbate a problem in another. Current forecasts show the economic slowdown to eliminate ~$4 trillion of global growth in the next four years. In addition, the European Central Bank (ECB) supervisory board chief Andrea Enria is expecting cross-border bank consolidation in the region to increase protection. Several banks now face higher capital requirements after displaying insufficient “responsiveness” to the ECB’s guidance on leverage finance. Although this is speculative for the time being, it shows banks are considering teaming up to brace for what may come. With global inflation at the forefront of most country policy makers, it remains a finicky task to not push the pedal too hard too quickly, or they run the risk of hurting the economy more than they are helping. The credit team will continue to monitor the results of this week’s meetings which will hopefully provide the world with more color on our current position.

LDI’s, Gilts, tax cuts, and rates: the anatomy of the U.K. credit dislocation.

While the central banks of most developed countries are pursuing a path of monetary tightening, the Bank of England (BOE) has had to implement quantitative easing (purchasing government bonds) to head off a significant dislocation in the country’s credit markets. Last month the new Prime Minister, Liz Truss, announced a large debt-funded tax cut as a key policy platform which sent bond markets spiraling as rates rose and prices cratered. This led to a systemic issue among the country’s pensions which had built significant positions in liability-driven investments (LDIs). LDIs are a derivative product that became very popular with U.K. pensions to generate better returns in a zero or negative rate environment. LDIs use interest rate derivatives and leverage to increase returns while also increasing the severity of loss if it occurs and have received quite a thumping from yields rising on government debt (Gilts). The BOE’s tightening has led to a poor year for bond returns which is similar to the U.S., however, the announcement of tax cuts led yields to skyrocket as investors attempted to determine how much the U.K. government would need to borrow in the coming years to fund the cuts. To stabilize markets and pensions, the BOE intervened by beginning a £5 billion a day gilt buying program which was increased to £10 billion on Monday while the government abandoned its tax-cutting plans for the time being. Unfortunately, the market continued to spiral leading the BOE to announce today that it would be adding £5 billion a day in inflation-linked gilt purchases (similar to our Treasury inflation-protected securities) to further stabilize the market. Most global credit markets have had a poor year from rising rates, but double-digit inflation, a weak pound, and a new administration in Downing have led to a more acute dislocation in the U.K. than global peers. While we don’t expect any spillover from U.K. markets to the U.S., the credit market across the pond does give us some direction on how much tightening domestic markets could bear.

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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