Doug Duncan, the chief economist at Fannie Mae, believes pressures from fiscal and monetary policy have brought volatility to the secondary mortgage market, creating a “higher-for-longer” scenario in the U.S. economy that mortgage companies should be ready to face.
“Every indicator that comes out, the market judges which way would the Fed move with it. Then, the 10-year response to that is the hazard,” Duncan said in an exclusive interview with HousingWire on Wednesday. “Different economists will give different points of view on that. But to me, it’s an excess of information.”
Adding the fiscal policy to that, Duncan said there’s more price sensitivity among investors in the U.S. Treasury, which brings the message to “watch for more volatility.”
Duncan expects the Fed to impose two rate cuts this year, in September and December. Mortgage rates are estimated to end 2024 at about 7% and fall to about 6.5% at the end of 2025. But home sales are expected to increase by about 3% this year, reflecting some income recovery.
“Incomes are growing but at a slow pace. House prices are still increasing but at a slower pace. Everyone’s waiting for the Fed to decide what the policy is going to be on rates. And that’s where the ‘higher-for-longer’ discussion comes in. It’s not soon,” Duncan said.
To deal with this landscape, some mortgage companies are “dormant,” Duncan said. Others are investing in products to help deal with affordability issues, such as zero down payment programs, which Fannie Mae is studying.
The government-sponsored enterprise (GSE) also thinks the Federal Housing Finance Agency (FHFA) will encourage it to offer single-family, closed-end second mortgages if a Freddie Mac product under analysis is approved.
This interview has been condensed and edited for clarity.
Flávia Furlan Nunes: What can we expect from the jobs report on Friday, and what will the consequences be for the Federal Reserve’s interest rate decision next week?
Doug Duncan: Our estimate of payroll jobs is about what we saw last month. If it comes out at 170,000 jobs, the market won’t shift much. If it comes out under 150,000, you’ll get a decline in the 10-year [Treasury note yield] as the market, which is trying to coach the Fed to cut rates, will say, ‘There it is. That’s what we need.’ But then when the Fed meets, they’ll say, ‘That’s not enough.’ If there are over 200,000 jobs, then the market will go the other way because it’s going to take longer for the Fed to act.
If you watch over the last couple of weeks, every indicator that comes out, the market judges which way would the Fed move with it. Then, the 10-year response to that is the hazard. That’s the result of what I view as an overcommunication by the Fed. They said, ‘We’re data dependent.’ So, the markets will look at the data and guess what they’re going to do. Different economists will give different points of view on that. But to me, it’s an excess of information.
I don’t expect the Fed to make any move at this meeting. We have in our forecast cutting 25 basis points for each of the September and December meetings. But if they don’t get three strong months trending the major data in the direction they want, we will take the September number out. The risks, right at the moment, are balanced toward less cuts.
Nunes: Is an increase in rates a possibility?
Duncan: No. They will have to message a lot about that. They’ve been pretty clear for a sustained time period that this is enough. The Fed will have to have at least two meetings in which they say in the press conference, ‘We seriously discussed the need to raise rates. We don’t see it now. But we had a serious discussion about it.’
That would put the market on notice that if there is additional information that goes the opposite direction of what the Fed wants, they could, in the following meeting, come up and say, ‘Things are not looking well. We are possibly going to make a move.’ So, they’ll gradually change their language, but it will take some time. Does that mean they would never be willing to shock the market? The probabilities are low. But if things moved fast enough, they would do what they think is necessary.
Nunes: One impact of this overcommunication you mentioned is volatility in the secondary mortgage market, correct?
Duncan: Yes, and I add that the Treasury announcements of their funding expectations are getting about as much attention as the Fed press conferences these days. The size of the debt and the deficit is such that the intersection between monetary policy and the needs of fiscal policy are strongly correlated now. That is a problem for the Fed in the sense that they have to be sensitive to where the Treasury is going to fund and how that will affect the shape of the yield curve.
In addition, I was reading a newsletter, and the analyst was looking at who are the investors in Treasury. Foreign investors were around 30% of Treasury holdings total. Of that, more than half were foreign-sovereign investors who were very price insensitive. But their share has fallen significantly and been replaced by entities that are more price sensitive.
So, if you add to the volatility of the markets from the Fed conversations, and then add some volatility due to increased price sensitivity on the Treasury side, that becomes a tough circumstance. In general, the message is, ‘watch for more volatility,’ but maybe from corners that you hadn’t previously been thinking about.
Nunes: Interest rates are just one tool the Fed has to impact the mortgage market. There’s also the sale of the Fed’s mortgage-backed securities (MBS) portfolio. What do you expect from this and what are the impacts on the secondary market?
Duncan: Because they know there’s already stress in the housing sector, at least in terms of volumes, they have left their MBS portfolio alone. It’s running off and it will continue to run off. It’s probably running off a little faster than they thought, but it’s not to their caps. If you go back to the first time the Fed discussed it, you can see [Chair Jerome] Powell was skeptical about using MBS. They have an explicit position: They want to exit the MBS market. That hasn’t changed at all.
But I would be very surprised if they sold out their portfolio. That would shock the market. No one has indicated that that’s a possibility. They just want to quietly let the MBS portfolio run off.
They’re being cagey exactly where they are because they’re not sure where it should be. If you project the pre-pandemic pace of the growth of the size of their portfolio, and you project a straight-line growth, they’re still well above what you would get to. They genuinely don’t know what the right place to be is. They feel as though they’re getting closer. And so they’ve slowed the pace. But they’re not going to do anything dramatic on the mortgage side.
Nunes: We are talking about monetary and fiscal policy, but there’s a chance of a presidential change next year. How does it add to your forecast?
Duncan: Obviously, we don’t know what will happen. Nothing is known at this time. In our forecasts, we run scenarios outside of our core forecast model, but until something is enacted or an announcement is made of the date of enactment, we don’t put it in our forecast until that occurs.
For example, does the President have the authority to remove the Fed chair? There are mixed opinions on that. I’m not an attorney in that space, so I don’t know. I do know that if that were legally possible, unless Powell were to resign his underlying seat — and there are no other openings — he would have to appoint one of the other governors to that position that’s already there. It’s a complicated question.
The whole discussion of the Fed’s independence — the Fed is never truly independent because there’s, as we were just talking about, the debt. Fiscal policy affects monetary policy. The purity of independence is kind of overstated.
Nunes: We can agree that we are in a ‘higher-for-longer’ scenario, motivated by the Fed’s actions, but you anticipate an increase in home sales. What factors do you believe are contributing to this trend?
Duncan: Yes, a 3% increase [in home sales for 2024]. We have rates at around 7% at the end of this year and closer to 6.5% by the end of next year. During that period, household incomes will be growing.
If the financing component of their housing stays relatively constant because rates stay relatively constant, and house prices are still positive, but they’re slowing, then the question is if income is growing faster than that. Our view is [income] will grow faster than that. Gradually, households will make up the ground from an affordability perspective because of the growth of their incomes. And it will be gradual, which is why you see a slow growth in our sales forecast.
Nunes: And what about the other components of affordability besides income?
Duncan: There are three important variables for affordability: interest rate, household incomes and house prices. There is a very predictable relationship between those variables.
The higher your income, the more expensive a house you’re likely to be able to afford. But that’s moderated by, if you have to borrow money to buy it, the rate of interest. As mortgage rates rise, the price of a house that you can afford to buy falls. What’s going to have to happen is some combination of interest rates falling, incomes rising, and house prices falling or slowing.
Incomes are growing but at a slow pace. House prices are still increasing but at a slower pace. Everyone’s waiting for the Fed to decide what the policy is going to be on rates. And that’s where the ‘higher-for-longer’ discussion comes in. It’s not soon I can’t tell you which of those [variables] will act the fastest.
Nunes: Do you believe there’s a psychological effect of a 7% rate since potential homebuyers are taking a ‘wait-and-see’ approach?
Duncan: It looks to me that that 7% number is a kind of a barrier. We’ve seen rates above 7% for a couple of weeks; we saw purchase applications fall by 5% each of the last two weeks. Just seems like that’s kind of a place where income has not grown enough. At the margin, people are unwilling to stretch to that level.
Nunes: Some good news for lenders in Q1 2024 was that their loss on each loan is narrowing. Are you optimistic this trend will continue?
Duncan: [Losses] are unlikely to end unless businesses take serious action to cut costs. And some are. I had a couple of industry consultants who I think very highly of come in and spend an hour with my research staff a couple of weeks ago. One of the things that they see — and have never seen before — is some of the smaller companies going dormant, furloughing their employees, and just keeping the elements of infrastructure in place to maintain their legal permissions and their business relationships. If the market turns, they can bring the step back from furloughs and grow.
Part of what they’re doing is protecting the wealth that they created from 2020 to 2022 and reserving that as an investment when the market picks back up. Some of them have been very serious about costs. And you know, one of the questions I heard one of these guys answer was, ‘What if it’s your family? He said, ‘If the objective is to maintain the capital value of the firm, then you lay them off.’ It’s a tough time. You are seeing some merger and acquisition activity, but not as much as you would think.
Nunes: Why are some mortgage lenders reluctant to do M&A deals?
Duncan: Some of these firms are consuming wealth by being loyal to their employees, losing money and staying in the business. That can’t go on forever. We’re telling people that this is a new regime; it’s going to be a higher interest rate regime. You shouldn’t expect 3% mortgages again in your lifetime unless there’s some catastrophic economic event.
The average 30-year fixed rate mortgage from World War II, early 1950s, up to 2000, was just under 6%. A 6% mortgage is not unusual, depending on what’s going on with incomes. So, the economy, inflation adjusted, grew about 3% [annually] on average for that entire time period. What about today? The Congressional Budget Office is the official estimate of potential GDP (gross domestic product) growth, and they estimate about 2.1% [growth in 2024].
What would be an analogous mortgage rate? The debt that we have to refinance is going to put pressure on the Treasury curve, and the underlying Treasury rates will be higher as a result of the need to fund all of this debt that we’re in. That said, over the housing cycle, mortgage rates might run from a low of 4.5% at the weakest point and a high of around 6% at the strongest point, with a median somewhere in the 5.25% to 5.5% range. To me, it would be a norm.
Nunes: I see some initiatives in the market to help borrowers when affordability is constrained, such as Freddie Mac’s single-family, closed-end second mortgage proposal. Is that something Fannie Mae is considering?
Duncan: It’s in the rulemaking process at FHFA. We haven’t said anything about it because we’re waiting to see what FHFA decides. It’s likely that if it’s approved, the FHFA — because they’ve been trying to balance the market — would encourage us to be in that space too. That would be a FHFA decision.
There are all kinds of views on either the issue of whether we should be in the [closed-end second mortgage] market, or the health of households who are extracting equity from their home. At different points in time, it has different impacts. So, when FHFA makes a decision, then you’ll hear from us.
Nunes: As an economist, how do you evaluate the economic impacts of a product like this?
Duncan: People have used the equity in their homes for many things for a long time. This is not new. A lot of it depends on the motive behind the extraction of equity. And there’s a huge list of things. Some of them are purely consumption. You may ask the question: Is that a good idea?
Well, for some households, it’s probably not a problem. For other households, it might be problematic. Some people have used the equity in their home as capital to found a small business. If that small business succeeds, you never hear about it. If it fails, it puts risk on the mortgage, and then you might hear about it. So, in any individual case, it’s very difficult to say whether it’s a good thing or a bad thing.
Nunes: Zero-down payment programs are also making a comeback. How do you see this trend and its risks?
Duncan: It all depends on how it is underwritten. And some things are out of your control. You may underwrite it very well, but maybe there are some weather issues that emerge, such as hurricanes or wildfires. We do have some research that’s going to come out — I’m not sure of the exact timing — where we’ve looked at the response of housing in a serious weather-related event, in this case, Hurricane Harvey in Houston.
We have a lot of data in that space. We’re trying to understand the households’ responses based on the level of the loss, the coverage of insurance, all those things, to be able to know how to underwrite those risks, and that would be something that we certainly would apply to a zero-down loan.
