Mortgage rate and real estate appreciation

The labor market improved in December, with the addition of 157,000 payroll jobs. Coupled with the upward revision of 34,000 jobs for the prior two months, 2.2 million jobs were created during 2004 – the most in a single year since 1999. The manufacturing sector also added jobs in December, consistent with late 2004 reports of a pickup in factory orders during the fourth quarter. The decline in the foreign exchange value of the dollar is likely to support additional manufacturing gains in coming months.

The minutes of the Federal Open Market Committee's (FOMC) December meeting confirm that the Fed views monetary policy as accommodative and this accommodation could be removed at a “measured” pace. In plain English, this means that the Fed is very likely to continue the course it started on last June—that is, quarter-percentage point increases in the Federal Funds target, announced at FOMC meetings, but not necessarily at every FOMC meeting. The FOMC is likely to nudge the Federal Funds target up to 2.5% at its next meeting (February 1-2), with further increases later in the year. We anticipate that the Federal Funds target will be set at 3.0% by midyear and at 3.5% by year-end. With inflation remaining tame (between 2% and 2.25% in 2005), the outlook for long-term interest rates, such as on fixed-rate mortgages, also remains very good, with fixed-rate mortgages up only about one-half of a percentage point over the year. Thus, the yield curve should continue to flatten over 2005, as it did over the second half of last year.

Higher, but still modest, mortgage rates means that the housing market should have another splendid year in 2005. Housing starts and home sales should fall short of the record pace of last year, but only by 1% to 2%. House price appreciation should also moderate, but come in at a brisk 7% appreciation pace for the average single-family house.

The flatter yield curve will likely entice lenders to increase the size of interest-rate discounts that they offer on ARM products in order to maintain ARM volume. Initial-rate discounts increased from 0.4 percentage points at the beginning of 2004 to 1.3 percentage points at the beginning of this year for the 1-year, Treasury-indexed product. The flatter yield curve will likely increase consumer interest in hybrid ARMs; the 5/1 hybrid is already the most popular ARM product, accounting for two-in-five ARM loans made last year. Higher mortgage rates will further reduce refinance originations as the year unfolds. Homeowners are likely to resort to HELOCs and other second-lien products to convert home equity into cash; over the year ended September 30, 2004, HELOCs and seconds accounted for almost 20% of single-family debt growth, and should contribute significantly to debt growth in 2005.