Headwinds & Housing Starts

Housing starts inched ahead in August to 891,000 from 881,000 in July (seasonally adjusted annual rate), the US Census Bureau reports. The August number was quite a bit lower than the consensus forecast, although it was in line with The Capital Spectator’s average econometric projection (see yesterday’s preview). Thanks to a revision that lowered July’s initial estimate, today’s August number posted a slight gain over the previous month. Nonetheless, it’s clear that higher interest rates are creating headwinds for housing.

The headwinds showed up in last month’s tally of newly issued building permits, which dipped to an annualized rate of 918,000 (seasonally adjusted), or near the lowest pace we've seen so far this year. That a sign that future construction activity may slow further in the months ahead. Yesterday’s update of the National Association of Home Builders/Wells Fargo Housing Market Index (HMI) also suggested that builders were turning a bit more cautious lately. “While builder confidence is holding at the highest level in nearly eight years, many are reporting some hesitancy on the part of buyers due to the sharp increase in interest rates,” noted NAHB Chairman Rick Judson in a press release. “Home buyers are adjusting to the fact that, while mortgage rates are still quite favorable on a historic basis, the record lows are probably a thing of the past.”

The shifting trend in starts and permits is clearer in the year-over-year changes. As the second chart below shows, there’s been a conspicuous deceleration in the annual growth rates this year. The good news is that starts and permits are still advancing at a respectable if no longer stellar rate vs. year-earlier levels. But for a number of reasons, including higher interest rates, it’s reasonable to assume that the housing recovery is entering middle age. That means that the big, easy gains are behind us and the prospects for growth going forward will continue to moderate.

How much growth will moderate depends on a lot of factors. One of the bullish variables is demographics. Growth in household formation has been high in recent years relative to the pace of new housing supply, which was temporarily depressed due to the real estate crash. But as the residential property market continues to play catch-up, the gap between supply and demand will move ever closer to something approximating equilibrium. Par for the course. Markets continually adjust to match buyers and seller. Sometimes that goes awry (think 2007-2010 for housing), but eventually a higher degree of efficiency returns.

The question, of course, is how a world with rising interest rates factors into the equation? No one really knows the answer at this point because we’re blind to two critical variables in real time. First, how fast will interest rates rise? Second, how far will they rise?

What we do know is that the national average for the 30-year fixed mortgage rate has jumped sharply in recent months, settling at nearly 4.6% last week vs. just under 3.4% as recently as this past May. Rates are probably heading higher still in the months and years ahead, but the pace of increase isn’t likely to match what we’ve seen since the spring. Or is it? On that note, it’s time to focus on the elephant in the room on such matters: the Federal Reserve, which will dispatch a fresh dose of guidance on monetary matters and beyond this afternoon. But the intense focus on today’s announcement from Bernanke and company still boils down to two questions: How much and how fast? The details, of course, will remain a mystery, even after today's central bank update. On the other hand, the Fed will probably make it easier to develop some reasonable guesses after we hear from the Federal Open Market Committee.