The recent broad-based weakness in US housing market data stands out from the otherwise robust economic indicators. As a sector that is highly cyclical and sensitive to interest rate increases, the US housing market is closely watched. It played a pivotal role in the great financial crisis but is also often an indicator of “normal” recessions.
Our findings suggest the US has reduced structural vulnerabilities in the housing market. Strong household fundamentals such as robust employment and wage growth lessen the risk of a sharp correction.
An important aspect of vulnerability is the starting point of household borrowing and, positively, US households have reduced levels of debt significantly since the crisis. Household debt as a percentage of GDP has fallen from a peak of 98.6% in 2008 to 77.3% in 2018. The cost of servicing mortgage debt as a percentage of disposable income has improved from the pre-crisis peak of 7.2% to 4.2% today.
But interest rates are rising…
The Fed’s commitment to gradual policy normalisation – which includes raising rates – is likely to result in a tightening of financial conditions and higher mortgage rates. The question is whether rates will rise sufficiently to strain households’ ability to meet repayments.
Most mortgages in the US are on 30-year fixed-rate terms, so the higher policy rate increases we are seeing now will feed through very slowly. In fact, the sensitivity of household debt servicing to policy rate in the US is the lowest among G10 countries.
According to Morgan Stanley, a quarter percentage point (25 basis points) increase in the Fed funds rate will increase households’ debt service by 4 basis points in the same quarter. Total mortgage default rates remain low at 3%.
Housing permits – official permission to build new homes, and thus an efficient tracker of activity in the market – are followed closely. Historically a fall in housing permits of more than 20% is seen as a strong signal for US recession over the near horizon. Currently, housing markets have slowed but continue to post small positive growth, far from the critical threshold level of -20%.
That said, there are undeniably bigger headwinds to US housing activity. We are seeing rising home inventories and a retreat in buyers’ confidence. Although we do not see material evidence of tightening in credit supply to the housing sector, mortgage approvals have weakened and the Fed’s loan officer survey points to modest tightening in mortgage credit standards.
Residential construction has been a detractor to GDP growth for the third successive quarter, and we expect sustained drag ahead. That said, the share of housing sector as a % of GDP in the US has steadily declined over the years.