Why Lower Rates Might Not Be Good

Posted by urbandigs

Thu Mar 1st, 2007 12:11 PM

Share |

A: There is a false perception out there that if the fed starts to cut interest rates that housing will be set up for another boom. I strongly disagree with this train of thought and here is why I think lower interest rates might not be good for housing, at least right away!

First off, with the economy still relatively strong (only starting to show some signs of peaking) and with oil/commodity prices still at very high levels, there is no way the fed will get involved in a long standing rate easing campaign. With that said, lets analyze what the fed might do.

If the fed cuts interest rates one or two times towards the end of the year, which is by no means a certainty, it is because they are starting to see signs that the economy is weakening and want to add some stimulation to prevent a recession.

So lets break that down. If the economy is starting to weaken, then stock prices will reflect that early on with a selloff. Since the stock market is a leading indicator of the economy, it will be the first to show signs that trouble might be ahead. Assuming this happens, paper profits and consumer portfolio values will restrict making people feel less confident and less wealthy. As this occurs, there will start to be talk of a fed rate cut as Ben Bernanke and company attempt to put a floor on how bad things might get.

In fact, the fed might even wait until there are real data points signaling a weakening economy before actually cutting; which is why many argue that the fed is lagging in its policy. In short, they want to know that something is actually happening and not any type of anomaly before changing monetary policy.

As the fed cuts rates, it is because the economy is getting worse. The more they cut, the worse off things really are and the more in need of stimulation to prevent things from getting real bad. While interest rates and lending rates might dip a bit, it will come at the expense of restricting wealth effect due to falling stock prices and job losses.

The first thing that happens in the beginning of a weakening economy is that corporations start cutting capital expenditures and other costs. The ripple effect begins. As corporations prepare for the worst, their spending cuts fuel the upcoming weakness that results in lower profits and profit margins reported. As this happens, job cuts are considered as another option.

THIS IS NOT GOOD FOR HOUSING!

Here is a chart of the unemployment rate dating back to 1997, charted monthly, derived from the Bureau of Labor Statistics website:



Now here is a chart of the fed funds rate and monetary policy changes during this same time:



Now, lets combine the two charts and see if any relationship exists between when the fed starts cutting rates and unemployment reports soonafter:



Hmmm..Very interesting! At least we know that when the fed is cutting interest rates, it is because the economy is weakening, and in a weaker economy unemployment usually rises.

We have seen a very strong economy for some time now which has been reflected in higher stock prices since 2003 or so. Now one can argue that todays economy is a global economy with tons of liquidity and historically low real interest rates, and I'm fine with that, but what worries me is the warning signs. I see commodity prices still at very high levels, a stock run up that is due for a correction, possible policy changes in Washington, a weak dollar, and signs of peaking profits and profit margins.

But put all that aside and trying to keep focused on real estate, I just don't see how one can argue that as the fed cuts rates the housing market will boom again! There is a reason the fed is cutting rates to stimulate the weakening economy, and it is those reasons that might not bode so well for housing in the near term.

As I mentioned before, the biggest threats I see to housing in the near term is a change in policy of lending standards (which is already happening as lenders get tougher in the loans they hand out restricting purchasing power) and job losses. If the fed starts cutting rates, then its because corporations might be in for some tough times that could very well lead to job losses. How could that be good for housing? Even if rates on the 30YR fall from 6.2% to 5.75%, if you don't have a job or take a pay cut, then you can afford much less of a home if at all.

UrbanDigs Says - I'm not a pessimist and hope you don't look at me as such a negative broker. Its just the way I see things and like to play devils advocate and talk about the stuff that few like to publicly talk about; especially in this business. If the fed cuts rates it is because they sense weakness which will ultimately be priced into equities and which will force corporations to take action. That is my fear. Don't get caught up in the idea that 1-2 fed cuts will make the housing market boom because deep down those rate cuts are in reaction to more serious underlying issues that will overpower lower lending rates! Rather, it is the nearing of the end of a rate easing cycle and when the fed starts raising rates again (because the economy is strengthening) that I feel is a more optimal environment for the next round of housing price appreciation.