In Depth Interest Rate Forecast 2011: What to Expect in the Bay Area and Why!

In Depth Interest Rate Forecast 2011: What to Expect in the Bay Area and Why!

The economy and housing markets have seen some rough times the last couple of years. But the good news is that last year we saw some stabilization – and 2011 should see us continue on the road to recovery.

To help you prepare for the coming year, we’ve put together an overview of what to look for in 2011. We start out by looking at the big picture and discuss the outlook for the overall economy, the stock market, and the all-important employment market. From there, we dig into what to look for in terms of the housing market, including home prices, the foreclosure crisis, compensation, new legislation that impacts the mortgage industry, and finally the all-important forecast for home loan rates in 2011.

Economic Outlook

Overall, the economy looks to have stabilized from the crisis situation a couple of years ago. Although we still have global economic and political concerns, particularly regarding the situation in Europe, the U.S. economy appears positioned for continued growth and strengthening. We expect that the U.S. economy will be moderately stronger this year, and will get an additional boost from Quantitative Easing 2 (QE2), as well as the recently passed Tax Package.

Over the past 5 quarters, Gross Domestic Product (GDP) in the U.S. has dramatically improved from where it was in 2008 and held on to those gains.

Looking ahead, we see the United States’ GDP finishing 2011 above where it ended last year – growing by as much as 3%. This is inline with other industry experts and friends we spoke to, like Knight Kiplinger, CEO of Kiplinger Publications and one of the most revered financial writers of our time. He agreed that he expects GDP to finish the year around 2.8%. Bob Weidemer, author of the highly acclaimed book “Aftershock”, told us he sees slightly more modest growth, perhaps around 2.5%, but still moving positively.

That growth won’t happen overnight, however. Instead, it will start out slow in the first half of the year, and pick up steam in the second half.

We see a portion of that growth coming from demand in other countries. Currently, the U.S. only derives about 12% of its Gross Domestic Product (GDP) from exports. As Knight Kiplinger said, “While that equates to a lot of money, it means that the U.S. relies less on exports than many other countries – and it means that there’s room to grow.”

One of the reasons for a growth in exports during the coming year is the declining value of the U.S. Dollar, as one of the major “non-stated goals” of the Fed’s Quantitative Easing program is that the U.S. Dollar will weaken. And we are already seeing U.S. exports tick up as the U.S. Dollar has weakened, because it makes our goods and services relatively less expensive to foreign buyers. The Fed would never outright say that this was a goal of QE2, as they have heavily criticized other countries such as China for acting similarly.

However, the bump in exports is good news for the U.S. economy as a whole, as well as individuals, because it sets the stage for growth while still allowing U.S. consumers to catch their breath. After all, the tough economic climate over the last couple of years has hit U.S. consumers hard, and has forced many Americans to reprioritize their family budgets to focus more on their savings.

Additionally, this will help large multi-national companies, which have a large influence on the economy, and in turn, the major Stock market indices. And stimulating our economy towards continued growth is the Fed’s main goal for QE2.

There is a flip side to the weakening Dollar, however, and that is that a weakening Dollar can have some negative impacts. For one thing, the US is an importing nation and a declining US Dollar will make imports more expensive. The softening Dollar will also hurt imports of capital – meaning foreigners investing money in US Dollar denominated securities. And as Bob Weidemer points out, “we need capital imports more than exports of goods.” Foreign investment in our Bond market is what has fueled relatively low interest rates, including home loan rates, for a very long time…and should foreigners start to shy away from purchasing our Bonds, rates would climb higher over time. Additionally, Oil is priced in US Dollars and if the “buck” weakens sharply it could cause oil and gas prices to rise.

Inflation on the Rise?

One of the ways that a stronger economy can impact rates is through inflation. Remember, at the end of 2010 the Fed initiated its second round of Quantitative Easing (QE2), with one of their stated goals being to avoid deflation, and actually create inflation.

This is an important topic to keep an eye on in the coming year and keep your clients and referral partners educated about, since inflation is the archenemy of home loan rates.

Why? Because home loan rates are tied to Mortgage Backed Securities, which are a type of Bond. So as Bond prices improve, so do home loan rates. But when inflation – or even just fear of inflation – grows, Bond prices fall. That’s because lower Bond prices are needed to give Bond investors juicier yields that will help outpace inflation.

Here’s an analogy that you can use to help explain this relationship to clients and referral partners. Think of inflation as the ocean and interest rates as a boat. As inflation (or the ocean’s tide) rises, interest rates (or the boat floating atop the ocean) have to rise as well. In other words, interest rates (or boats) must always be higher than inflation (or the ocean) in order to compensate investors.

Right now, the headline numbers in the US show little inflation overall…but we already saw significant inflation in particular items like commodities, food, and oil – which were driven by a weak US Dollar and increasing demand from emerging countries like China and India.

But with the Fed’s QE2 and the stimulative measures introduced to help strengthen the economy, we could be looking at a 1.5% increase in consumer inflation by the end of 2011 – still within the Fed’s comfort zone of 1 – 2%. So inflation should not be a threat this year, however, the unprecedented amount of debt accumulation on the part of the US could spark significant inflation down the road. It’s easy to see why Bob Weidemer feels that “the medicine the government has been using to boost the economy (QE2)…will eventually become the poison.”

Housing Industry

Home prices began to stabilize during 2010, and homes sales showed some signs of encouragement. We expect more of the same in 2011, although there will be some additional headwinds.

After a modestly good start to the year, home prices could actually decline slightly in some areas, particularly depending on the health of the local job market. In the end, however, home prices should eventually and slowly begin to firm up toward the end of the year.

Another headwind that could weigh on home prices is the overhang of several million distressed properties. The moratorium on foreclosures has ended and all of the major lenders have resumed foreclosure procedures. At the end of last year, 3 Million homes were in foreclosure activity, with over 1 Million repossessions. Foreclosure expert Rick Sharga of RealtyTrac said the industry will exceed both of those numbers this year. “Banks are statistically getting better at modifications and short sales, but neither is increasing fast enough to offset foreclosures,” said Sharga.

Overall, we expect to see accelerated rates of foreclosures in the 1st Quarter until things settle to normal during the 2nd Quarter and rest of the year. This could extend the housing downturn a couple of months longer.

That said, there are also many potential homebuyers who have been waiting on the sidelines to step in and purchase a home at still affordable rates and home prices. Waiting much longer could prove to be costly for those homebuyers, who will likely see both home prices and home loan rates move higher in the year ahead…and make sure you are messaging that out to your prospects, clients, and referral partners.

One thing we are sure about is that regardless of how the mortgage industry changes, people will still be buying houses and they will need to get a mortgage in order to purchase those houses. As Jim Milano put it, in the mid-1990s everyone was saying that there was no way the mortgage industry would survive all the changes that were taking place back then, but in the end those concerns were worked out. “It can seem a bit overwhelming right now,” said Milano. “But we’ve been through this before and the industry has always managed to adapt and survive.”

For now, the mantra seems to be: plan and prepare as best you can, but be ok with a little bit of uncertainty as the industry wades through and digests the details. We made a number of legislative webinars available last year on the challenges facing the industry, but here’s some insight on the major developments that will undoubtedly impact your business in the near future.

Home Loan Rate Outlook

Now for the big questions: Where will home loan rates go in 2011? And why?

Let’s start by looking at where we’re at as we enter 2011. Although rates are still near historic lows, a look at the Bond chart over the last few months shows the huge run-up in Bond price and the subsequent price decline at the end of 2010, meaning rates have trended higher since early November.

Indications are that those unbelievably low home loan rates seen during 2010 may be behind us. In fact, there are only a couple things that would bring back the lows that we saw in early November 2010:

1. If the Fed’s recent round of Quantitative Easing falls on its face and doesn’t meet its mission of creating inflation, boosting Stock prices, lowering unemployment and creating consumer demand. If that happens, Bond prices could make some gains as the threat of deflation reemerges. But this is a long shot. As the saying goes: “Don’t fight the Fed” – which means that if the Fed wants to raise inflation, it most likely will.

2. If the financial problems and uncertainties in Europe that we saw in 2010 worsen significantly in 2011. This would drive investors into the safe haven of the U.S. Bond market, which would help Bond prices, but probably only modestly.

Realistically, the economy is improving, and as it does, home loan rates will gradually increase over time. With the Fed Funds Rate at zero and the likelihood of a rate hike possible but somewhat small at the end of the year – home loan rates should not spike significantly higher. This is further supported by an economy that will be growing, but not at a torrid pace during 2011. And because inflation should remain within the Fed’s comfort zone, it shouldn’t put too much upward pressure on rates this year.

We expect rates to stay relatively low during the beginning of the year, but gradually rise higher. By the end of the year, we expect to see rates around 5 – 5.5% at the top end…making it the third best year on record for rates, just behind 2009 and 2010. Freddie Mac Chief Economist Frank Nothaft agrees with our assessment, telling us he expects rates to stay in the range of 4.75 to 4.875 in the early part of 2011, then gradually moving higher.

The good news is that historically speaking – 2011 should still offer exceptionally low rates. As Knight Kiplinger said, “rates are still extremely low, but are seeing a rebound from the ridiculously low rates.” That’s a good way to put it, and it helps reframe the situation in clients’ minds, so they don’t think of a home loan rate at 5% as “high.” To help you with that conversation, show clients the 30-Year Mortgage Rate History table on the MMG site (dating back to 1971) to drive home that these are still some of the best rates most of us have seen.

It’s important to help clients and referral partners understand that rates won’t simply rise in a straight line. In fact, looking at the Bond chart over the past two years, it’s easy to identify moments when Bonds and home loan rates were able to rally. But in 2011 despite some momentary rallies, the trend overall is for rates to increase over time.

That means you need to prepare your clients ahead of time and explain that you monitor many different factors in order to identify the most opportune moment for them to lock. And when that time comes, they need to be prepared to pull the trigger and not look back.

As Ed Conarchy shared late last year in a special Conarchy’s Corner video:

Pilots often say “It’s better to be on the ground wishing you were in the air, than in the air wishing you were on the ground.” Similarly, Ed says, you need to help your clients understand that “It’s better to be locked and wishing you were floating, than floating and wishing you had already locked.”

Use this simple script yourself when meeting with clients and advising them to lock at the opportune moment. And remind them that by the time news of a small drop in rates hits the mainstream media and reaches the average consumer, the opportunity has already passed – and it’s typically too late to take advantage of it.

The Big Picture…and the Bottom Line

Although people tend to talk about the economy, the stock market, and employment separately in the news, the reality is they’re all related. Many people won’t understand the relationship between rates and the economy.

So make sure you use the changing economic climate – and your understanding of it – as a way to establish your expertise with clients and referral partners.

For example, you may find that you need to point out that an improving economy leads to better corporate earnings and increased manufacturing demand, which in turn leads to increased hiring.

In addition, all of the aspects discussed in our forecast influence the housing market and home loan rates. One of the biggest influences is employment, so improvements in employment will be good for the housing industry. After all, people who are unemployed, under-employed, or are afraid of losing their jobs are less likely to purchase a new home.

In terms of home prices, a more secure employment market can help home prices stabilize, as fewer people are at risk of losing their homes to foreclosure. In addition, the improvements in the labor market should open the door for more first-time homebuyers to join the ranks of homeowners.

That said, it’s important to remind clients that all real estate markets are local…and that means that there can be enormous variations across the country. Explain to clients that in areas where employment is struggling, the housing market will continue to struggle as well. However, in many parts of the country where the bottom has been tested and employment is improving, we’ll see the housing market on the mend in 2011. Use this as a lead in to discuss the employment situation in your area – and remember that we continually update an Unemployment Rate by State chart on the MMG site, so use this information when you talk to clients. This conversation can help you explain to clients why it’s so important to work with you to monitor the overall economy as well as the local market conditions to make sure they’re getting the best loan program for their unique situation.

But home prices and homebuyers aren’t the only aspects of the housing market impacted by the direction of the economy. As we’ve said, 2011 should look better than 2010 in many respects. But, good economic news is a double-edged sword, as it leads to higher rates. That’s right, good economic news is bad news for home loan rates.

There’s actually a pretty simple explanation for this seemingly strange phenomenon. But, you first need to make sure clients and referral partners understand two important financial concepts:

1. Big money managers – who are always in search of higher returns – avoid holding onto cash. So they invest in both Stocks and Bonds.

2. Home loan rates are actually based on the performance of Mortgage Backed Securities (MBS), which are a type of Bond.

So whenever the economy is on fire and there are good economic reports along with positive economic news, investors tend to put more money into Stocks. That’s because Stocks are more risky, but they generally offer higher returns. To do this, however, investors must remove some of their money from less-risky Bonds. This decreased demand in Bonds causes Bond prices to worsen, which causes home loan rates to rise. We have already started to see outflows on money from Bond Mutual Funds…the most in years. This tells us the everyday investor is selling Bonds and driving prices lower. That trend may continue a bit in 2011 until yields reach levels to re-attract investors.

When you explain those factors to clients, they begin to understand the relationship between good economic news and higher home loan rates. And, more importantly, they understand why they need you as their knowledgeable mortgage professional.

Vintage Mortgage Group is a bank and a broker in the San Fransisco Bay Area with decades of experience. If you would like to discuss mortgage rates please contact us below.


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