Hello, everyone, and welcome to On The Market. I am your host, Dave Meyer. And today, we are going to talk about big news in the investing world. Basically, what happened at the Federal Reserve meeting last week. If you haven’t heard yet, they raised rates, but of course, that was pretty widely expected and was not the big news. But what did happen on top of that headline news was really important and gives us probably the clearest picture yet that we have seen over the last couple of months of where the Fed is intending to go.
I’m not sure if everyone listening to this knows this, but on top of just raising the federal funds rate, which they did, 75 basis points, they also have a press conference, which is really closely followed by investors and nerds like me. And they also release something called the Summary of Economic Projections, where the Fed actually tells you where they think the economy is going and what they’re intending to do about it. And not a lot of people look at that, which I think they should because the Federal Reserve, as we talk about on the show all the time, the Federal Reserve sets the rules for the entire investing world, not just real estate investing, but the stock market and bonds as well. And if the Federal Reserve is telling you what they think is going to happen and what they intend to do about it, you should probably pay attention.
But I know not everyone wants to read through that. So I did, and I will tell you what’s in there and give you some of my opinion and some other analysis about what this Fed announcement means for real estate investors because they have been raising rates for the last couple of months. But, to me, this meeting was probably the most impactful for the future of the housing market, let’s say the next six, 12, 18 months, than any of the other meetings. And I’ll tell you why about that in a minute, but that’s why we’re going to do this show today. That’s why we’re going to go deep into this topic. So you’re definitely going to want to stick around for this. But first, we are going to take a real quick break.
All right, let’s just start with the obvious here, which is about interest rates. Basically, the Fed raised the federal funds rate, which, again, I just want to make this clear that the federal funds rate and what they are raising is not mortgage rates. It’s not really even a interest rate that impacts any consumer directly. It’s actually a short term interest rates that banks use to lend to one another. And this is wonky, but it basically sets like the baseline interest rate. And then, every other interest rate, like the yields on bonds, or what you pay for a mortgage, or a car loan, or credit cards are all in some way based on this federal funds rate. It’s basically the lowest interest rate. And everything else from there goes up based on risk, and reward, and all sorts of things like that.
So what happened was the Fed raised this federal funds rate 75 basis points. And if you don’t want to know what a basis point is, it’s just a weird way of saying 0.01%. So when I say 75 basis points, that basically means 0.75%. So it went from 2.5 to 3.25, that’s 70… Excuse me, sorry. It went from… Yeah, did I say that right? It went from 2.5 to 3.25. That’s 75 basis points. And so, that’s where it is now. And the federal funds rate is actually a range. So now it sits between three and 3.25%.
Now, that, again, was kind of obvious. People actually thought there might be 100 basis point hike after the most recent inflation report because that was so much higher than people were expecting. But the Fed decided to pursue a more predictable course, I would say, and just did the 75 basis point hike. That’s what people were expecting. They typically want to do something that’s not super out of line with the market’s expectation, and that’s what they did. Not a lot of news there.
But in addition to this immediate hike, we now know that rates… And this is the important part. We now know that rates will likely climb higher in the coming months, and actually, into next year, into 2023. And you might be wondering, how do I know this? How do I know what’s going to happen with rates? Well, the Fed just tells us this. It’s not rocket science. I’m not looking into a crystal ball. And like I said at the top of the show, they release something called the summary of economic projections. And after every meeting, they do this. And it tells you they put out expectations for inflation and economic growth. But what we’re looking at today is really what their expectations are for monetary policy. Basically, where are they going to set the federal funds rate.
And to me, the most important part of this entire summary of economic projections, at least for what we’re talking about today, is known as the dot plot. And the dot plot is basically a poll for every Fed official who’s at these meetings, and it asks each individual person where they think interest rates should be over the next couple of years. So they have a vote and they say, “Where do you think interest rates are going to be in 2022, 2023, 2024, 2025?” And they put it all on a dot plot. But the dot plot is a little bit confusing. I think for our purposes here today, it’s actually just easier to look at the median expectation. So, instead of looking at each individual expectation of each Fed official, let’s just take the average of what Fed officials think is coming over the next couple of years. And basically, what that shows is that the people who make this decision, that the Fed officials are the people who decide where the federal funds rates go, and they expect it to go up to 4.4% by the end of 2022.
Now, remember, we just experienced our third 75 basis point hike in a row. And it’s saying that we are still going to go about 125 more basis points by the end of the year. So that could be another 75 point hike and then a 50 point hike. There’s two more meetings this year. So that’s probably what will happen. I think that’s the most likely scenario. So going up significantly more by the end of 2022. And then the Fed thinks it’s going even higher in 2023. The median there is 4.6%, so not much higher. It sounds like the Fed is thinking that what they’re going to do is raise rates aggressively through the end of the year, and then a little bit more in 2023, but not much more.
If you’re wondering around the out years, 2024 and 2025, they do have it coming down to somewhere around 4% in 2024, and then dropping all the way down to below 3% in 2025.
Now, no one knows what’s going to happen, right? If you watch the press conference with Jerome Powell, he basically said he doesn’t know what’s going to happen. So I don’t put a lot of stock in what’s going on in 2024 and 2025. There’s just too many variables. That’s basically the Fed saying they want to get back eventually to what they would call a neutral interest rate. When interest rates are super low like they’ve been for most of the last 10 years, that’s known as easy money. We are now entering a territory where it’s tight money, where it’s hard to borrow. But the Fed has this vague concept of neutral where it’s just like the right amount so there’s not inflation, but there’s economic growth. And that’s what they think the 2.75, 3% rate is. And so, that’s where they want to get to eventually. But I think we should take very seriously what is happening and what they’re saying they’re going to do for the rest of this year and into next year.
So I don’t know what’s going to happen. No one does. But the only data that we have is that the Fed says they’re going to raise rates for the rest of this year and a little bit next year. And I’m going to take their word for it personally. I think that’s going to happen. And higher rates have really big implications for the housing market. But I just want to say it is important to note that when I am saying in this episode, high rates, I’m actually really just speaking relatively. And what I mean is they’re high in a relative context. They are high compared to everything that we have seen since the Great Recession. Since the Great Recession for the vast majority of the last 12 years, the federal funds rate has been at zero, right? It’s been at zero.
So, yes, what if we have a Fed funds rate now at 3.25 like we do, that is low compared to where we were for most of the last century. But what matters here is that it’s a shock to the system. It is still low in a historical context. But if you go from zero to three really quickly like we have, this can be pretty shocking to the economy. And I do think we’re going to see some shocks through the economy. So that’s what happened with the federal funds rate.
The second thing I want to talk about is about mortgage rates because that’s what really is going to impact the housing market directly. And as I said, the federal funds rate is not the mortgage rate. And I just want to explain what that means. So the Fed funds rate, like I said, impacts things like bonds. And most particularly what we want to think about here is the yield on the 10-year treasury bond. This is basically a bond that the US government puts out and they pay an interest rate on it. And yields, when the Fed funds rate goes up, yields on these bonds tend to rise for a lot of reasons I’m not going to get into today, but just know that that happens.
And the reason I’m mentioning this is because mortgage rates are super closely tied to yields for the 10-year treasury. And so, we are seeing yields go up all year and that’s why mortgage rates are going up. So just know that, that they’re mostly tied to bonds. And what you want to look at, if you are trying to predict where mortgage rates are going to go, is that bonds are what matters here, not really the Fed fund rates.
So, my analysis of what’s going on and based on this analysis is that mortgage rates are probably going to go up over the next couple months. I wouldn’t be surprised, let’s say, if we see mortgage rates enter the low sevens over the next couple of months, but I’m not expecting rates to just keep going up linearly. We’ve seen this really aggressive rise in mortgage rates, but I think that is going to slow down even despite this news that the Fed is going to raise rates into 2023. There are actually some analysts who thinks mortgage rates, even with this news, are going to go down next year. And let me explain why.
First and foremost, mortgage lenders, they are forward looking. It’s not like they’re sitting around being like, “Oh, the Fed is probably going to keep raising rates all of 2022, but I’m going to keep my mortgage rates that are dependent on bond yields, and everything else. I’m going to keep them low and wait to see what the Fed does.” No, that is absolutely not what they would do. That is too risky. It’s just bad business. And so, what they do is they base their mortgage rates based on where they think interest rates for bond yield, and the federal fund rates are going to be several years down the load. They want to be able to make money even when the Fed raises rates into the future.
And so, they have been pricing these Fed raises into mortgage rates all year. That’s why mortgage rates went up starting in June. They didn’t wait for the two 75 basis points hikes since we’ve had since June. They went up past six or near six back in June. And now, starting a couple months ago, in August, we were starting to see rates go up again. And that’s because people were anticipating what happened in this fed meeting. So it’s not like all of a sudden the Fed announces that they’re raising rates and mortgage brokers are like, “Oh, damn. We got to catch up. We got to raise rates.” They’ve already done this. They already did it. And so, now they’re, of course, going to adjust a little bit. Yields and bonds are going to adjust based on what the Fed said, but they have already been thinking about this and the adjustments are going to be smaller. And in these times of uncertainty, mortgage brokers are going to err on the side of caution and make rates go higher to cover their basis. They want to make sure that they have good rates even if the Fed keeps raising rates even higher and higher.
The second reason that I think that mortgage rates are not going to just keep skyrocketing is based on what I said before about the 10-year treasury. They are very, very closely correlated. For any other stats nurse out there, the correlation is near one. It is 0.98 from my analysis. So that just means, if you’re wondering what that means, is when one goes up, the other goes up, when one goes down, the other goes down. They’re very tied. They move in lockstep.
But, usually, in normal times, for the last 70 years or so, the spread between yields and mortgage rates, so the yield on a 10-year treasury and the mortgage rate is about 170 basis points or 1.7%. So mortgage rates are always higher than the bond yield. And the reason the spread exists is based on a bank’s business. If you are a bank and you have millions or billions of dollars to lend, you have to decide how to lend it to people. You can lend it to me as a home buyer or you can also lend it to the US government in the form of a bond. After all, that is what a bond is. You’re basically lending the US government money and they are going to pay you back with interest.
And so, if the bank is saying, “Hey, yields on the 20-year treasury are going up, so I can earn nearly 4% on a trend year treasury.” And the government bond is considered by pretty much everyone the safest investment in the entire world. The US government always pays them. They’ve never defaulted. They always pay. And so, it’s considered the safest investment. So if you go to a bank and you’re like, “Hey, you can earn 4% with virtually no risk,” the bank is like, “Yeah, that’s pretty good.” So then when I go and ask for a mortgage and I’m like, “Hey, can I get a mortgage?” They’re not going to lend to me at 4% because I’m not as credit worthy as the US government. So they’re going to charge a premium to me because even though I pay my mortgage every single month, I as an individual homeowner is, unfortunately, a bit less credit worthy than the US government. And so, they charge a premium. And that premium is usually 1.7%. So if a bond yield is about 4%, mortgage rate is about 1.7%.
But I did some analysis, and what’s going on right now is that the spread is actually higher than it is normally. It’s at 232 basis points, so about 2.3%. It’s normally at 1.7%. And that is because there’s all this uncertainty. We don’t know what’s going on with the Fed. We don’t know what’s going on with inflation. Are we in a recession? What’s going to happen? So, mortgage lenders, like I said, are bringing extra causes and they’re increasing the spread between mortgages and bond yields. And that’s probably going to stick around for a little while. But if the Fed holds their line and does what they say they’re going to do and inflation does start to come down, I think people will start to feel a little bit more comfortable. And the spread between bond yields and mortgages might start to come down.
Of course, bond yields could keep going up a lot more, but again, bond yields have largely priced in these Fed decisions. So those two things make me feel that, although I do expect rates to go up, they’re not going to go up like crazy because we could have some reversion to the mean with the spread between bonds and mortgages. And a lot of this has already been priced in for months.
That is why Mark Zandi… You may have heard of him. He works for Moody’s Analytics. He’s one of the most prominent economists in the world. And he expects, even after this week’s news, he expects the average rate for a 30-year fixed rate mortgage to be 5.5% in 2023. He actually thinks it’s going to come down. So that might happen. I don’t really know. I’m not an expert in bond yields. I’m not an expert in mortgage prices, but I do think these two things do suggest that, although they probably will go up, again, I wouldn’t be surprised if we get into the sevens, that we are probably not going to see this linear mortgage rate growth like we’ve seen over the first three quarters of this year continue throughout this year and into 2023.
Okay. So far we’ve talked about interest rates, mortgage rates. Now, let’s talk about the Feds focus because this, to me, was really telling what happened in the press conference afterwards. And nerds like me, economic reporters, finance people, all love the press conference because Jerome Powell, he gets up there, he reads some carefully prepared statement, and it’s all like a game. The Fed has an enormous responsibility in the world. They dictate so much of financial markets and economies, and they’re very careful about what they say. People count how many times he says recession. Or back when they were saying calling inflation transitory, they would count how many times he said transitory to try and understand what’s going to happen next. So people make this huge game out of it. It’s kind of ridiculous.
But the reason I think this it’s important to note right now is because the press conference yesterday, or two days ago… And again, this will come out a week from now, so you’ll hear this a week after, but I’m recording this two days after this news came out. Jerome Powell, he was pretty darn clear about what he is expecting, clearer than he usually is. And I think he said some things that were really noteworthy that tell us the Fed’s intention and where they’re going to go.
So, during the press conference, a Washington Post reporter, named Rachel Siegel, pointed out to Powell that the Fed’s own summary of economic projections… Remember, that’s that data that they just give out when they meet. They are predicting now that unemployment over the next two years is going to rise to 4.4%. And that is a rate at which typically brings about a recession. Remember, we are not technically in a recession. By many people’s definition of a recession, we are, but the National Bureau of Economic Research has not officially declared us in a recession yet. But this reporter was pointing out to Jerome Powell that the Fed is basically predicting a recession.
Here’s what the chairman said back. And I’m going to paraphrase briefly here, but he said, “We have always understood that restoring price stability,” which as an aside just means reducing inflation. So he says, “We have always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging. And we don’t know, no one knows whether this process will lead to a recession, or if so, how significant that recession would be.”
And I know that’s a lot of mumbo jumbo, but basically, what the Fed chairman, the guy in charge of the economy just said is, “We think that controlling inflation is going to bring about at least modest increases in unemployment and no one knows if it’s going to bring about a recession or how bad the recession would be.” He’s basically saying we need to bring down inflation and we don’t care if unemployment goes up a bit, and we don’t care if it goes into a recession because inflation is such a problem that we have to pursue this.
Now, today, I don’t want to get into a debate whether inflation or recession is more important. Everyone has their own opinion about that. I’m just want to tell you what he’s saying and my interpretation of that. So that’s basically what he’s saying is like, “We’re going for it. We’re sending it. We’re going to keep raising rates. Recession be damned. Rising unemployment be damned.” But I do think it is important to note that he was basically saying if unemployment starts to get really bad, that’s when they would back off. But 4.4%, which is a pretty good increase from where we are today, they are comfortable with that. So, no one knows, but that’s basically what they said.
As it relates to housing and the need for the housing market to cool off, Jerome Powell stated, and I quote, “What we need is supply and demand to get better aligned so that housing prices will go up at a reasonable level, at a reasonable pace, and that people can afford houses again. And I think we probably, in the housing market, have to go through a correction to get back to that price.” Okay. What does that mean? It means Gerald Powell is planning on a housing correction. And personally, I think that’s what they want. A big part of inflation has been shelter inflation, both in terms of rents and housing prices. And I think Powell and the Fed know that to get inflation under control, they need housing to go down. So he’s basically saying, “Yeah, I know. Housing market is probably going to cool and probably going to go negative at some point on a national basis, and we’re cool with that.” Basically, all told, the Fed is saying, “Yes, we are willing to risk a recession. Yes, we are willing to risk job losses. And yes, we are willing to see housing market correction in order to bring down inflation.”
If you just read the transcript and I recommend you do, we can put a link to it here, he wants this. This is how you bring down inflation, is you get prices to come down and you get people to stop spending money. So he wants a recession. He wants job losses. He wants a cooler housing market because that would bring inflation under control. Of course, the Fed could change their mind, but this press conference, he said, in very clear terms, that they’re going to hold the line inflation. They’re going to keep rates high there probably, even going to raise rates, even if this is going to cause all the things that I just said.
So that’s my interpretation of Jerome Powell’s speech, is he was not pulling any punches. He is not messing around. He is telling us all in very clear terms what to expect. And, to me, that is high rates, housing market cooling significantly, probably going negative in a lot of markets, not every market, but in a lot of markets. We’re probably going to see unemployment go up. And we are probably going to see a recession officially, even though we’re not officially in one yet.
All in all, everything we’ve talked about today, basically, why I wanted to make this show and why I think this is so significant is because over the course of this year, over the course of 2022, many investors have been hoping for a Fed “pivot.” And basically, a lot of investors had this theory that the Fed would raise rates up to a point where it would slow things down. The housing market would cool like it has been. Companies would probably be hiring less and things would start to cool off. But they wouldn’t risk a deep recession, or a lot of job losses, or huge crash in the housing market, and they would keep it around two and a half, 3% sort of that neutral Fed funds rate that I was talking about.
But, to me, this press conference just completely kills that theory about a pivot. The Fed is extremely careful. And they are very deliberate about what they say. And if they were keeping their options open for a pivot, they wouldn’t have said the stuff that Jerome Powell said yesterday. The data it shares, everything they said right now is that they’re going to stay aggressive in the fight against deflation even if it causes economic pain elsewhere in the economy. And that is what we should expect.
The most notable implication of all this is for housing prices. And we all know by now that as rates have risen over the last couple of months, demand in the housing market is starting to drop off, and prices, that is putting downward pressure on prices. We’ve talked about that a lot in the shows. Most recently, we are seeing a lot of West coast markets start to decline. Most haven’t yet, as of this recording, this is the end of September, have not yet declined year-over-year, but a few, San Francisco and San Jose, have. And that’s where we are.
That’s said, I think, over the course of this year, the housing market has actually held up surprisingly well to downward pressure. We’ve seen rates double. Yeah, we’re seeing prices come off their June highs and their down month-over-month, but year-over-year, almost every major market is up. And that is what I thought. The [inaudible 00:25:39] market is resilient. There are a lot of reasons, fundamental reasons why the housing market is resilient, even in the face of the rising rates that we’ve seen so far.
But now, knowing that a mortgage rates are going to stay high for the foreseeable future is going to be a much bigger test than what we’ve seen so far. Because, if there was a pivot and rates peaked and people could get adjusted to that and maybe come down a little bit, then the housing market, I think it was probably going to hold up pretty well and you could maybe have a decent year in 2023. But now, I mean if you were going to have a year and a half of mortgage rates above five and a half, maybe up to 7%, to me, that is going to put a lot more housing markets at risk for declines. And so, I think everyone needs to keep that in mind. 2023, right now, at least on a national level, is looking like a flat year at best, and is more likely a down year, even on a national level, is what I’m starting to think, by next summer. I don’t think it’s going to come in the next couple months, but I don’t know, I really don’t. These are just my musings that I’m sharing with you right now.
And the reason I say this is just because affordability in the housing market it’s just too low. We did a whole episode if you haven’t listened to that about affordability, but it’s at 40 year lows. That means it’s harder right now for the average American to buy the average priced home than it has been since the ’80s. And that’s not sustainable in my mind. And there’s basically two ways that we could improve affordability. One is rates start to come down because that makes homes more affordable. But we just got told that rates aren’t coming down. And so, the only other way for homes to become more affordable, other than massive wage growth, which we are not going to see, is that housing prices start to come down and make homes more affordable. And so, that’s why I think there’s going to be this sustained downward pressure on the housing market.
And I want to be clear that even given all of this news, I still do not think we are heading for a crash. And I define that as a declines at a national level of more than 20%. I don’t think that is going to happen. The credit quality is still good. Inventory is actually starting to level off. People who know more about this than I do, professional forecasters, think that, really, the downside, the biggest downside is somewhere around 10%, as in on a national level. We don’t know if that’s what’s going to happen, but it is worth noting that that’s what a lot of experts and people who forecast this stuff think.
The second implication other than housing prices is rent growth. And I think, if we do see a recession, if we see job loss, those things, combined with inflation are probably going to lessen demand for apartments. You see in these types of adverse economic conditions, people move in with their friends and their family, and that’s known as like household drop declining. The total number of households people occupy a housing unit could go down, and that lessens demand.
It’s worth noting that rent is pretty stable. It doesn’t really fall that much even during a recession, but I think rank growth is really going to start to come down. It already has in August. It was at 11% year-over-year, which is still really insane, but way lower than it’s been over the last couple of years. So I think that trend is going to continue.
And then, the third thing is that we could see increase foreclosures and evictions, but we’re still a good way off from that, right? If there’s a recession, we don’t know if it’s going to be a bad one. We don’t know what is entailed in that. And right now, the data shows that homeowners are paying their mortgages, renters are paying their rent. And so, I’m not immediately concerned about that, but it’s obviously something we’ll keep an eye on over the course of the next year to make sure that if we see something that changes, I will certainly let you know.
So, that’s what I got for you today. I just want to say that I personally am still investing. I do think that there are opportunities that are going to come over the next couple of months. We’re going to be working on some more shows about how to invest in 2023, different strategies that are going to work, different strategies to avoid, opportunities that might present themselves. So definitely stay tuned for that. We’re going to have a lot more 2023 planning content on this podcast over the next couple of months, but that’s what I have for you today. Hopefully, you guys understand this.
If you’re interested in this, I do recommend at least watch the press conference with Jerome Powell and see what he was talking about. You can look at the summary of economic projections and look at some of the data that the Fed is sharing with you. These are things that you should know if you’re an investor, if you’re risking large amounts of your money and the Fed is this active and they have so much control over what happens. If you were me, I would learn as much as I can.
Thank you all so much for listening. I really appreciate it. If you want to give me any feedback about this show, have any thoughts, you can do that on Instagram where I’m at, thedatadeli. If not, appreciate you all being here. I’ll see you next time.
On The Market is Created by me, Dave Meyer and Kalin Bennett. Produced by Kalin Bennett, editing by Joel Esparza and Onyx Media. Copywriting by Nate Weintraub. And a very special thanks to the entire Bigger Pockets team. The content on the show On the Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.