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December 20, 2016

Who Should You Listen, The Fed or The Market?

By George Yacik, INO.com

It never ceases to amaze me how some people still react to and hang on to the words of former authoritative figures long after they’ve ceased to be relevant.

The other day 76-year-old Martin Sheen – Charlie’s father, for those under 40 – led a group of liberal has-beens and C-list “celebrities” urging Republican members of the Electoral College not to authenticate Donald Trump’s election. Does Sheen really believe people still care about what he thinks, if they ever did? Guess so.

While I admit that Janet Yellen and the other members of the Federal Reserve have hardly reached Martin Sheen status as irrelevant, I have to wonder about the market’s reaction to Wednesday’s decision by the Fed to raise interest rates an entire quarter point. Why did anyone care?

Not only had a rate increase been telegraphed by the Fed for the past several months, but the market had already moved well ahead of the central bank. If anything, all the Fed did was validate what has already happened. The Fed rate hike was largely a moot point, yet many in the market, commentators as well as investors and traders, are treating the move as if the Fed broke new ground, which it certainly hasn’t.

Actually, the Fed has been talking about raising rates for the past year, which was the last time it did so. Which is why the Fed has squandered a good deal of its credibility. Since last December, the Fed has continued to hint that it was going to tighten monetary policy and raise short-term interest rates, only to change its mind at decision time. Now, finally, it has done so.

Which is why I think the market reaction to the Fed announcement has been way overblown.

Perhaps the market has been more focused on what the Fed says it might do in 2017, namely raise rates three times, rather than what it actually did. But given the Fed’s recent track record of hinting it’s going to do something and then not doing anything, why should we believe it this time, especially since we really don’t know what’s going to happen next year that might affect its decisions?

My main area of professional interest the past 30 years has been residential mortgages. To hear some people in that industry talk about the Fed rate hike, you would think disaster is about to befall the business.

The first – and worst – thing the rate hike is going to do is kill refinances, they say, never mind that the Fed has no control over long-term interest rates, and what it did Wednesday has no effect on those. And those rates have been rising since July. So what’s the news?

In fact, people who wanted to refinance have had at least five years to refinance at 4.5% or below if they wanted to or were able to. If they waited too long, that’s their tough luck.

Industry people are also worried that the rate hike will prevent people from buying homes. That’s more of a valid argument, but it still has some flaws.

First of all, there’s no guarantee that rates will continue to rise. Following the 120-basis point jump in the 10-year Treasury note yield since July 4, it’s reasonable to believe that the bond market selloff has been overdone and that we can expect rates to level off or actually decline in the near term. Secondly, higher rates may actually make home buying more affordable in the coming year.

How so, you ask?

One of the biggest problems home buyers – especially first-time buyers – have faced in the past year hasn’t been overpriced mortgages but overpriced houses. Many people in many localities have found themselves priced out of the market because home prices have risen so much. One of the reasons for that rise has been a lack of housing supply, but another reason is cheap financing. What’s keeping housing somewhat affordable is low mortgage rates, not low prices.

However, if mortgage rates are going up, then it’s reasonable to expect that home prices will head in the opposite direction, or at least the increase in prices will moderate or even flatten out. That should benefit the home purchase market, then, not hurt it, or at least have no effect at all.

This higher rate scenario assumes improved economic growth. But we don’t really know if that will be achieved. While we can certainly hope that that will happen, and more confident that it will under President Trump than President Obama, that remains to be seen.

Until then, the market should focus on what the market is saying, not what the Fed says. It’s just following the market, too.

Courtesy of George Yacik via INO.com

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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