A Brexit Silver Lining
The historic decision on June 23 by the people of Great Britain to exit the European Union (the "Brexit") initiated upheaval in equities worldwide and caused both political and economic ripple effects throughout the world. Over $2 trillion in global equity value was wiped out within a few days.
Some effects of the Brexit decision appeared transient. For example, US stock markets have already regained a large part of their immediate losses. Other Brexit side effects, such as increased volatility in global equity and currency markets are likely to plague investors for some time. However, there is one positive effect of Brexit that may have staying power: low US mortgage rates.
The Federal Reserve's plan to raise interest rates in several increments during 2016 has already been thwarted by messy real-world events and troubling economic data. Now, the economic uncertainties triggered by the Brexit vote make it even less likely the Fed will raise interest rates at all this year. Some analysts have speculated that 2017 and 2018 rate hikes are looking less likely as well, given that there will be up to two years of contentious negotiation to execute the Brexit.
With the Fed keeping interest rates at historic lows, mortgage rates are more likely to stay near their historic lows as well. According to the weekly Freddie Mac survey, the benchmark US 30-year fixed mortgage rate fell to an average of 3.48% in the wake of Brexit, down from 3.56% the previous week and from 4.02% at the beginning of the year. The Zillow Mortgage rate ticker came in even lower at 3.34%.
How can you, as a potential homebuyer or investor, take advantage? That depends on several variables, including your acceptable price range and where you plan to buy.
How Low Can Interest Rates Go?
Clearly, there is some practical floor to interest rates; no sane lender is going to offer you an interest rate that is an upfront money-loser for them. However, there is real debate about where that floor is located and how close rates may get to it.
Historically, the average of US 30-year fixed mortgages has been around 8.3%. In broad context, 30-year fixed rates have been going down in a sawtooth fashion since the spike that topped 18% during the 1981-1982 recession. Rates were near 10% at the beginning of the 1990s, near 8% at the beginning of the 2000s, and near 5% at the beginning of the 2010s. If that trend were to hold, at the beginning of the 2020s, the 30-year fixed rate would begin the decade between 2% and 3%.
Is a sub-3%, 30-year fixed rate really possible, or even a sub-2% rate? It's not an unreasonable conclusion based on other economic conditions. For example, who would have thought 10 years ago that there would be a market for government debt paying negative interest rates? They are now a fact of life in Japan, Denmark, Sweden and Switzerland, as central banks try to stimulate economic growth and force money back into equities and commercial drivers of growth.
What's the upshot of all this for American homebuyers? Simply put, it's that mortgage rates will remain ultra-low for the near term, and perhaps far longer. That's good news if you're shopping for a home anytime soon. But what about fixed income investors — how might they be impacted by Brexit and today's uber-low interest rate outlook? The answer to that is a bit more complex.
Broadly speaking, lower rates are always positive for fixed income investors. That's because the value of their existing debt instruments — ranging from Treasury bonds to municipal issues to mortgage backed securities — rises as interest rates fall"". What's more, banks can easily sell their current mortgage loans into the secondary market to be packaged as mortgage-backed securities (MBSs), and still make a profit — as long as investors believe the underlying mortgages have been carefully underwritten.
So far, investors seem to be comfortable that Dodd-Frank has done its job and that fewer risky mortgages are being issued, and that the ones that are issued have been properly assessed for risk within MBSs. According to etfdb.com, the eight ETFs dealing with mortgage-backed securities are returning anywhere from 1.1% to 5.2% year-to-date. It's possible that rates will not just stay low but instead continue to drop based on economic uncertainties, making MBSs an even more enticing investment for safer returns.
Thus, while lower interest rates in general are good for fixed income investors, lower mortgage rates in specific favors investments in MBSs and mortgage funds. Should the EU continue to fracture over the next 24 months, uncertainty will deepen and the effects described above should continue. At the moment, a further EU split seems unlikely — but so did the Brexit not so long ago.
Don't Forget Supply and Demand
While banks and policy makers offer a starting point with interest rates, in the end, they are driven by basic supply and demand. Brexit effects will certainly influence supply and demand both directly and indirectly.
Lower interest rates can help to release pent-up demand in the housing market — assuming that several factors fall into line. Potential homebuyers must be able to qualify for loans and find a suitable home to buy. Tight credit and a weak supply of homes had been throttling sustained growth in the housing market, but those factors have been improving. Even without the Brexit vote, the housing market was on track to have its best year since the housing crisis.
Conversely, should Brexit effects create a worldwide economic slowdown that costs jobs or reverses wage growth in the US, the low interest rates become less relevant — you can't take advantage of historically low interest rates if you can't afford to buy a home at all.
Local supply and demand will produce interest rate variations and the occasional distorted market. Analysts at Fitch Ratings point out that already low interest rates have spurred the market enough to create a 30% increase in home prices nationally (based on the Case-Shiller indices), but in some active markets (California, for example), the increase is greater than 50%. According to Fitch estimates, the Los Angeles and San Francisco areas are currently overpriced by 10% to 15%, and still lower mortgage rates could result in further overheating of the market and make a sharp price correction more likely.
Could lower rates reinforced by Brexit increase refinancing efforts as well as home sales? That's a difficult call. Theoretically, lower rates should induce more homeowners to refinance and save money — but interest rates have been at historically low levels for so long that most people who are in a position to refinance have already done so. Sub-3% interest rates may not be enough to bring people back into the market since the difference from an existing homeowner's rates may not be large enough to make a difference after refinancing costs.
Brexit-induced market uncertainty should help keep interest rates low for some time or cause them to drop even further toward record-low territory. If you are in the market for a home and are a well-qualified buyer, you can take advantage of these low rates for some time, assuming you can find a suitable home to buy.
Are you still saving up for a down payment? Brexit could be good news for you, because you have more time to save up for a suitable down payment. However, if your local market is running short on supply and high on demand, you could end up being priced out of your preferred market.
Keep an eye on your local housing market to see how Brexit's effect on mortgage rate manifests itself in your neighborhood. We hope that the effects are positive and you are able to purchase your dream home. The old saying still rings true...location, location, location.