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EScroogeJr (< 20)

The era of high interest rates is over?

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September 16, 2007 – Comments (3)

This coming Tuesday the Fed is meeting to lower interest rates. It is debatable whether this will be a 0.25% cut or 0.5% cut, but it's all but certain that the current 5.25% rate won't hold.

Currently, all the market cares about is the 0.25% vs. 0.5% debate. But the more important question is whether we'll ever see a 5.25% interest rate again. I think it's exceedingly likely that we never will.

Our housing market has reached the stage where there is no going back. A $1 mln house can't hold its value unless the interest rates are low. And it can't appreciate further unless the interest reates are very low. And making houses appreciate 10% a year is the cornerstone of our economic policy. This is what America is all about.

There is no way the government can allow prices to drop. A zero percent growth for one year has already presented very serious problems, and a very modest 1.5% drop would have ruined the whole financial system if the Fed had not rushed to rescue the banks with liquidity injections. The system simply cannot allow any further declines. A 10% drop in housing prices is all it would take to make banks go belly up. And an increase of mortgage rates from 6% to 6.6% is all it would take to cause this 10% drop. In other words, the Fed's choices today resemble a 1-directional diode: they can lower the rates, but once lowered, they can't take that cut away.

As housing resumes its growth, which I expect it will, the Fed's choice will only get more limited. Ten years ago, taking the rates back to 8% was still feasible. Four years ago, housing prices would still allow to go back to 7%. Three years ago, prices were already at the level where 6% was the maximum rate that would not ruin the system. And two years ago, when the prices peaked, 5.25% became the maximum rate that could be sustained, and even that - only as long as the Chinese were buying our mortgage paper, creating the "inverted yield curve" paradox. Now, as the Fed is facing the problem of engineering the next stage of the housing rally, it has no options but to take the rates below 5%, and forever.

The bottom line is that today's US economy is like a world champion who is addicted to doping and if he wants to hold on to his title and his medals, the only thing he can do is increase the dosage. This is why as we're preparing to say goodbye to the 5.25% interest rates, we may as well wonder if it's a goodbye or a farewell.

   

3 Comments – Post Your Own

#1) On September 17, 2007 at 4:22 PM, QualityPicks (25.87) wrote:

If rates keep coming down, we'll end up with stagnant to down home prices. I don't see how housing can resume growth any time soon.

There are several components that affect housing prices. Most people will always pay as much as they can for the most house they can afford.

So how much can people pay for a house? Well, you have to look at incomes and income growth, interest rates (10 year, not the fed funds rate), the type of mortgages out there, etc. I follow my area closely. I'm not sure if you live in CA or not, and maybe your area is not as bad. But from census information only 17 percent of the families in my area make more than $110k a year. Yet, if you make $110k a year, you cannot even afford a two bedroom condo (at the current $525k price). Actually, since these are families, they actually need a 3 bd room, which is $575k. But go to a calculator plugin $110k income, maybe a car payment, current interest rates, and you get that you can afford a $400k house at the most (with 10% down). This is where some initial solid demand would be for housing. But we are far from it.

So buyers and sellers get to battle it out. There are still buyers out there. But there are more sellers out there. And a lot of these are foreclosures, so they are desperate sellers. Buyers are less and less every day. Most emotional buyers already jumped-in "at any cost". Now we have more cautious buyers. But there are still those buyers that think they are catching a bottom or a great deal because prices are now 10% lower. After these buyers are gone, what's left? Well, there are still tons of people that want to buy a house, but can't afford it. You have to come down to a solid level of demand. Right now, we are 20%-30% off from that level.

As interest rates and incomes change, so will affordability. But right now, while prices are disconnected from affordability you will only have "weak demand". Inventory levels are high right now, and expected to get higher.

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#2) On September 17, 2007 at 7:56 PM, retailsails (95.60) wrote:

Interest rates will always have to come back, mainly because if they don't the dollar will get killed...actually that's already starting to happen...

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#3) On September 17, 2007 at 10:08 PM, EScroogeJr (< 20) wrote:

Good point, JR10022, but you're forgetting that the government wants to kill the dollar so we can pay back our 10 trn foreign debt with green toilet paper. They don't want to kill it altogether, or too abruptly, but they'll be glad to kill it just it a little. (If you need a reason to look at BRIC stocks, here you've found one).

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