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Mortgage rates rise again, homebuilders benefit from “sense of urgency”

Brent Nyitray, Sr Real Estate Analyst

The recent bond market sell-off bumps up mortgage rates again

Mortgage rates are the lifeblood of the housing market, which is why Bernanke and the Fed began conducting quantitative easing (or QE) in the first place. Lower rates allow home owners to refinance, which increases their disposable income and helps stimulate economic growth. Lower rates enable first-time home buyers to move out of an apartment and into a house, which means higher consumption (and good things for home improvement retailers like Home Depot and Lowe’s). Consumption accounts for some 70% of the U.S. economy, and consumption has been depressed since the housing bubble burst. The Federal Reserve would prefer to keep rates as low as possible for as long as possible.

The sell-off in the bond market has been swift

Mortgage rates have been trading in a narrow range of 3.4% to 3.75% for most of this year. After bottoming in late April, rates have increased as investors began to pile into the equity markets. Q1 earnings were generally good, and the economic data has not been weak enough to cause fears of another recession. The market has been discounting the end of quantitative easing, and last week’s FOMC meeting confirmed the market’s fears that the punch bowl is being taken away.

The average 30-year fixed-rate mortgage increased by an astounding 35 basis points the week ending May 31, and it went out at 4.1%. The week of the FOMC meeting, it increased even more—by 42 basis points. Last week, rates ticked up another three basis points, but we are starting to see some stability in the TBA market.

Effect on homebuilders

Homebuilder stocks, such as Lennar (LEN), Toll Brothers  (TOL), Standard Pacific (SPF), PulteGroup (PHM), and KB Home (KBH), have rallied strongly over the past year, with the Homebuilder ETF (XHB) rising smartly. As real estate prices have rebounded, orders have increased for builders, with some reporting year-over-year increases of 50% or more. Lower mortgage rates will certainly increase demand, and with first-time homebuyers beginning to return, move-up buyers who are looking for their dream home will be able to sell their starter home.

Given that the economy could have depressed household formation numbers, there is real pent-up demand for housing. Housing starts have been below historical averages for the past ten years. With low mortgage rates, increasing demand, and a strengthening economy, homebuilders now have the wind at their backs. Generally, homebuilders reported good earnings, with the exception of NVR, which focuses more on the East Coast. The builders that have exposure to the red hot West Coast market did very well. For homebuilders, the top-down macro picture looks good.

The fear for homebuilders has been that the 100 basis point rise in rates will cool off demand for new homes. We had three important data points last week that show this hasn’t been the case. Both Lennar and KB Home reported second quarter earnings and said that the increase in rates is creating a sense of urgency with buyers. Finally, pending home sales (which are contract signings) increased 7% in May. So far, the increase in rates is not cooling housing demand.

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