The author of the article questions whether investors are in a state of unreality. For the past few years, a massive amount of free money has sparked a sense of euphoria in many financial markets. Last month, Ben Bernanke sent markets into a tailspin by mentioning that the Fed would start "tapering" its bond buying program.
By Brett Arends
July 12, 2013, 7:44 a.m. EDT
Market Watch
A while back, a very good friend of mine had an operation on his arm. In the aftermath, the doctors gave him some Vicodin to deal with the pain. When I next saw him, his arm was in a sling. I asked him how he was doing.
He was in a terrific mood. “I’m as high as a kite,” he said and started laughing. I’ve never seen him so happy.
I don’t mean to be Mr. Gloom, but I sometimes wonder if investors are in a similar state of unreality. For the past few years, a massive dose of free money, thanks to zero-percent interest rates and “quantitative easing,” has sparked a similar sense of euphoria in many financial markets. One shouldn’t overdo analogies, but free money and Vicodin have one thing in common.
They wear off.
Federal Reserve Chairman Ben Bernanke lifted markets with remarks hinting that the era of free money may go on longer than some had feared. Last month, he sent markets into a tailspin just by looking forward to the day when the era of free money would come to an end — when the Fed would start “tapering” off its purchases of government bonds and, indeed, when short-term interest rates would rise.
Yet commentators on TV are making sarcastic remarks about last month’s “taper tantrum.” But it is all a matter of degrees. Sooner or later, this is going to end. The Vicodin will wear off.
Consider the U.S. real estate market.
It has been going through a dramatic two-year recovery since hitting rock bottom in 2011. According to the National Association of Realtors, the median new home sold for $208,000 in May — a gain of 11% in a year and 21% over two years. Median prices are now back to their highest level since before Lehman Brothers collapsed.
“The market’s been going crazy,” says Svenja Gudell, senior economist at Zillow.com, the real estate site. Normal rates of growth ought to be closer to 3% a year, she says.
Naturally, this is coming out of the biggest housing crash since the Depression.
Yet a key factor in the real estate recovery was the collapse in mortgage rates, which made it much, much cheaper to buy a home. It is surely no coincidence that the housing market finally took off in the second half of 2011 — just after the summer budget showdown in Congress, quantitative easing by the Fed, and debt deflation fears sent rates plummeting to historic lows. According to Bankrate.com, average rates on a new 30-year loan fell from 4.5% in May, 2011, all the way down to 3.4% last fall.
Yet even though the stock market is now shrugging off the taper tantrum, the bond and mortgage markets aren’t. According to Bankrate, in May, before Bernanke spoke, you could get a 30-year mortgage for 3.6%. Now it will cost you 4.6%.
In January, an American family who wanted to buy a median home would have paid $170,600, according to the National Association of Realtors. (There are seasonal factors making winter purchases cheaper). Assume they borrowed 80% of the price at prevailing mortgage rates then, which according to the Fed were 3.4%, they would have faced an annual interest cost of about $4,600.
Today, a family hoping to buy a median home will pay $208,000, and 4.6% interest. Annual interest on an 80% mortgage: $7,600.
In other words, the effective cost of buying the median home in the U.S., when measured in terms of the actual cost of the mortgage per month or year, has risen by more than 50% in just a few months.
And this, if markets are to be believed, is just the beginning. I tend to follow baseball legend Casey Stengel’s advice, and avoid forecasting anything, especially the future. However, in this circumstance, some speculations are unavoidable.
Historically, long-term Treasury bonds have typically yielded at least 2% above inflation. The bond market today is forecasting inflation over the next 10 years of about 2%, so in a normal environment — without financial Vicodin — you might expect the 10-year Treasury to yield about 4%.
In those circumstances, 30-year mortgages would probably cost well over 5%, possibly approaching 6%.
At 6%, that family buying a median home today would saddle themselves with an annual interest cost of nearly $10,000, more than twice what it was at the start of the year and about twice what it was a year ago.
It is alarming to think how much of our economic recovery, halting as it is, is simply the product of financial engineering and artificially low interest rates. What will happen when those rates go back to normal, and the Vicodin wears off?
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