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   ARTICLE   |   From Scotsman Guide Residential Edition   |   November 2016

The Joy of Interest Rate Forecasting

Getting predictions correct isn’t easy, but it is still important to try

At a Glance

Basel III, an international regulatory framework for banks

Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to do the following:

  • Improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source;
  • Improve risk management and governance;
  • Strengthen banks’ transparency and disclosures.

Source: Bank for International Settlements  

Occasionally, voting members on the Federal Reserve’s Board of Governors (the Fed) forecast what they believe the federal funds rate will be over the next two years and for the longer term. Simultaneously, economists and a host of other industry experts base their forecasts on what they think the voting members will do, but in recent memory those forecasts have tended to miss the mark.

There are two key reasons for this. One is that, in general, interest rates from the post-WWII era to 1981 rose steadily, but have fallen steadily from 1981 to the present. Any statistical model one might use, over any length of history, will estimate the mean tendency — and today we are at historical lows — so the models predict rates will rise.

The second reason is that we are in a new paradigm in the post Great Recession world, which features massive new levels of regulation, high bank-capital requirements, unprecedented monetary policy intervention and muted economic growth on a global scale. Any model based on pre-Great Recession data is virtually useless in today’s environment.

So what is a forecaster to do? Originators need dependable insights to help make good decisions for their clients. Who should know better what the Fed will do than the members of the board itself? If they can’t even forecast their own actions with reliable accuracy, the rest of us are unlikely to do much better. Or can we?

To be sure, the recent rate environment has yielded benefits. According to the August 2016 Equifax Consumer Credit Trends Report, just under 4 million new first mortgages had been originated year to date, as of this past June, an increase of 5.3 percent from the same time in 2015. The total balance of new loans at that time was $973 billion, an increase of 8.5 percent. But despite the upside, there is still a great deal of uncertainty in the marketplace, leaving originators to wonder: Why is predictability so elusive right now?

What is affecting rates?

Inflation worries are only part of the equation. Extraordinary monetary policy interventions have been put into place since the start of the Great Recession. These are not limited to the Fed; they are being used around the world. Of particular note are quantitative-easing programs, where central banks invest in sovereign debt — U.S. Treasury bonds, in the Fed’s case — and in corporate bonds of various types, like the securities issued by Freddie Mac, Fannie Mae and Ginnie Mae.

At the same time, global-banking regulators acting under the Basel III Agreement have greatly increased the amount of capital that banks must hold. Banks cannot lend this stock of capital, so their only choice is to invest in high-quality sovereign debt. Thus, you have central bankers hoarding sovereign bonds, while banks are working to build capital reserves using these same instruments making bond prices soar — and rates fall.

The increased capital standards are not intended to keep rates low, but rather to ensure there are sufficient reserves available for banks to survive a recession and subsequent credit cycle. This helps protect investors and taxpayers.

What now?

Five years ago, few, if any, experts could have imagined that this rate environment would sustain itself for so long and that we would see near all time-lows on mortgage rates. The Brexit “surprise,” when Great Britain voted to leave the European Union, caused 30-year fixed rates to fall to 3.41 percent, not far from the all-time low of 3.31 percent. Italy’s “leave” referendum, expected to go before voters this month, could surprise markets again, and send rates down again.

Forecasters of interest rates have no meaningful idea about what comes next. 

Today, many experts are adjusting their estimates of interest rates downward because everyone thought they’d be going up by now. Lenders and loan originators should be prepared for the eventual scenario when rates start to rise, however. When that happens, refinance activity will decline. Some forecasters predict that the refinance market will dry up to less than 10 percent of mortgage originations, while others have it lingering for a longer timeframe.

History is not really a guide here. We have been in a period of generally falling interest rates for 35 years. Over short periods, we have seen interest rates rise, and there has been a marked drop in refinance activity during those times, but only down to about 20 percent of origination volumes. Some also are concerned that an interest rate hike will decimate the home-purchase market, but home-purchase activity has not responded significantly to changes in rates looking back to 1990. The economics of the transaction explain why.

Homes are not homogeneous. They vary in size, amenities, neighborhood and property characteristics. Potential homebuyers might determine they can afford a $300,000 home, put 20 percent down and borrow $240,000. Their monthly principle and interest payment at today’s rate of 3.5 percent is about $1,080. Suppose rates rise to 4.5 percent before they lock in. At $240,000, the mortgage will cost $1,215 a month, leaving the family to decide to cut other expenses by $125 per month and buy their original dream home, or reduce their mortgage to $215,000 to keep their payment the same. This means they can buy a $275,000 home if they put the whole $60,000 down as originally planned.

As rates rise, there is an incentive to buy “less” house, so home-price growth may slow. Current conditions, however, are marked by a severe shortage of homes available for sale, so we should not expect home prices to fall unless local economic conditions are bleak. Moreover, the alternative to buying is renting, and rents have been rising rapidly since the end of the recession, so bidding wars will likely remain.

What about existing homeowners with low interest rates? They are probably less likely to make a move to a new home, which is why home purchases may slow, depending on how fast rates rise. Thus instead of a move-up buy, we might see increased interest in home additions financed through low-cost home equity loans. Indeed, the home equity lending market is booming thus far in 2016

The August 2016 Equifax report shows that $77.7 billion worth of Home Equity Lines of Credit (HELOCs) were extended from January to June 2016, a gain of 12.1 percent year over year. Home equity installment loans also are on the rise. Over the first six months of this year, $13.1 billion in home equity loans were originated, a 6.6 percent gain over a year ago.

The big picture

The famous economist and diplomat John Kenneth Galbraith once quipped: “Economists don’t forecast because they know; they forecast because they are asked to.” There is no time like the present to reinforce that forecasters of interest rates have no meaningful idea about what comes next. The models say “up” while policymakers intentionally — or unintentionally — work to keep them low.

As of the end of this past August, the consensus forecast among leading banking and investment economists was for a three-eighths of a percentage point rise in the average 30-year fixed mortgage rate in 2017 versus the current expected average for 2016. The range of forecasts run from no change all the way up to an increase of three-quarters of a percentage point. If the former is correct, then almost certainly there will be weeks over the coming year when rates may touch or go below the magic level of 3.30 percent and reach a new all-time low.

Interest rates are more likely to rise than to fall, given that they are already so low. But the timing of the change in trend and pace of the rise are still big unknowns. The mortgage market has significant momentum in the current environment, with mostly refinance activity at risk should the rate scenario shift. That said, all any economist can say with confidence is that rates will rise. Someday. Maybe.


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