The Relative Anchor in Rates

The 30-year fixed mortgage rate is inching ever closer to 5%, up from 3.35% in May of 2013. This is causing people to worry about how this will impact the housing market.

The 10-year treasury yield is above 3% been after bottoming out under 1.4% in the summer of 2016. This is causing people to simultaneously worry about both the stock and bond markets.

The Fed Funds Rate currently stands at 2.25% after being on the floor at close to 0% from 2009 through the end of 2015. This is causing people to worry the Fed is going to snuff out the economic recovery by raising rates too far, too fast.

The inflation rate over the past 12 months was 2.3%. That’s up from a minor bout of deflation experienced in the financial crisis. This is causing people to worry about the effects of inflation on the economy and financial markets.

Each of these rates is elevated from the lows of this cycle but it’s fascinating to compare them to levels seen historically and the not-too-distant past.

For example, 30-year mortgage rates were as high as 6.5% in October of 2008, basically the eye of the storm during the recession and stock market crash. They were still 5% in early-2011. Mortgage rates began the 1990s, one of the best economic and stock market decades on record, at nearly 10%. The average never went lower than 6.5% for the entire decade, which stood at 8.1% over the whole period. The 1980s saw average mortgage rates north of 12.7% and got as high as 18.6%. The 30-year average never fell below 9% for the entire decade.

The Fed Funds Rate was 5.25% in 2007 before falling through the floor by the end of the financial crisis. Since the 1950s, the Fed Funds Rates has been at or below current levels just 25% of the time. This short-term policy rate averaged 10% in the 1980s, 5.2% in the 1990s, and just less than 3% in the 2000s. It reached more than 19% in the early-1980s when Paul Volcker was trying to extinguish sky-high inflation. It’s been in double-digit territory almost 10% of the time since the 1950s.

Going into the tail end of the dot-com bubble in 1999 the 10-year treasury yield stood at 6.3%. It averaged close to 7% over the 1990s. 10-year yields were 10% or higher from 1979-1985 and didn’t fall below 7% until 1992. Yields were around 5% or so heading into the Great Recession by the end of 2007.

Inflation was more than 5% per year in the 1940s and 1950s. In the 1970s it was close to 8% annually. But in the 1950s, 1960s, 1990s, and 2000s, inflation was more subdued in the 2-3% range.

So by almost every measure — mortgages, Fed Funds, 10-year yields, and inflation — interest rates are still low by historical standards.

Markets, however, do not care about absolutes — they care about relatives. It’s not good or bad that matters so much, especially in the short-to-intermediate-term; it’s better or worse.

One of the reasons this is the case is the anchoring and adjustment heuristic. This is the idea that people use a specific baseline or reference point and then adjust their probabilities from that starting point when making decisions.

Two economists performed a study on people who moved from one real estate market to another to test this theory. They found people couldn’t help but anchor to the prices of their previous real estate market when moving to a new one.

People who moved from expensive cities rented higher priced apartments than people arriving from less-costly cities (this relationship held true across different levels of wealth and taxes). So people who moved from costly cities to cheaper ones tended to keep their housing costs constant and buy more house than they needed while people who came from cheaper towns ended up in smaller places. And once people stayed in a new city for some time they tended to get used to the housing prices in the area and readjust based on the new market reality.

This isn’t even one of those behavioral psychology heuristics you can call irrational because in many ways it makes sense.

Each and every housing market is unique in its own way just as each and every market environment is different. The variables are constantly changing while investors continuously update their priors based on new information that comes to light.

Rate levels that may have worked in past environments could potentially cause a depression today. There are so many moving pieces that it becomes almost superfluous to compare today’s rates to historical levels.

Inflation plays a role. Economic growth plays a role. Demand for credit plays a role. The consumer balance sheet plays a role…and I could continue.

But expectations play a much larger role in the financial markets than most people assume. When interest rates rise or fall, and the stock market rises or falls, those movements are rarely being driven by the fundamentals of the day.

More often than not, what’s really happening is investors are resetting their expectations. Sometimes those expectations ratchet things up while other times markets get knocked down a peg or two.

Everyone wants to pinpoint the cause of the current stock market downfall. The level of rates probably has something to do with it, even if it’s not the entire story.

Investors may have anchored to the low rates they became accustomed to for a few years and are now adjusting their expectations going forward.

Further Reading:
Why the Next Bear Market May Feel More Painful


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