Perspective on the Housing Boom

As the Fed has raised interest rates from the lows of 1.00% in June, 2003 to the current rate of 4.00% in November, 2005, the housing market has raged on. How is this possible? From Peter Warburton's excellent book, "Debt & Delusion":

It is important to realize that gradual rises in interest rates during a property speculation are frequently ineffective. As long as property is appreciating in value at a faster annual pace than the interest rate paid by the borrower, the fire will keep burning. Only sudden rate increases inject sufficient fear into the market to challenge the predominance of greed.

The Fed has telegraphed its interest rate moves very clearly with the language of its statements, and its successive hikes have been all been anticipated by the market. The ability of market participants to accurately forecast Fed activity is a relatively recent phenomenon, and it has led to unprecented carry trading by hedge funds, proprietary desks, and other market participants. The unheralded amount of borrowing-short, lending-long has compressed long-term interest rates, keeping mortgage rates at historical lows for years. Homeowners have certainly taken advantage of this, and effectively transmitted the expansionary monetary policy the Fed begins at the short-end of the yield curve into rapidly rising housing prices.

As the spread between the Fed Funds rate and the benchmark 10 year Treasury narrows with each rate hike, what will happen? Things will really get interesting when the Fed is staring the decision to invert the yield curve in the face. At this point, there may be much less consensus in the market and surely some will be surprised whatever happens. Is the highly interest-rate sensitive housing sector ready? Let's look at US home mortgage borrowing.


The trend is clear-US households have been steadily ramping up debt, fueling the impressive gains seen in real estate prices. Perhaps we hear the maxim that real estate prices never fall significantly, or at least they maintain their value if the gains are not as impressive. We need only look at Japan to see how false that commonly believed statement is...