Housing Market Forecast: A 15% Drop in Prices

The chart below is both fascinating and scary. It shows the 30-year US fixed mortgage rate (on the x-axis) against US home prices (on the y-axis.) since 1971. US home prices are measured by the S&P/Case-Shiller US National Home Price Index.

35% downside?

The chart illustrates that the level of the 30-year mortgage rate explains roughly two-thirds of (the variation in) US home prices (R-squared = 65%.) Unsurprisingly, a higher mortgage rate is associated with lower home prices and vice versa.

The disturbing part of the chart is highlighted by the orange-dotted oval, which contains the combinations of home prices and mortgage rates since April last year. Since then, the 30-year mortgage rate has topped 5%. Yet, home prices have remained extremely ‘rich’ relative to history. For example, taking a mortgage rate of 7%, home prices would have to fall a staggering 35% only to get near the other dots reflecting a 7% mortgage rate.

Connecting the dots – Adding supply

As the chart above demonstrates, mortgage rates are not the only factor explaining US home prices. The amount of houses on the market – directly reflecting housing market activity – is another important factor providing valuable information on where home prices are heading.

A simple regression model using the 30-year fixed mortgage rate and months of supply of new one-family homes provides a pretty accurate estimate of the change in home prices 12 months from now. Hence, it is a forecasting, not just an explanatory model. The chart below shows the monthly estimated home prices using the regression model. It suggests home prices will bottom at around 255 in September. This represents a 15% decline from the latest-known, December level. The ugly part of US home prices has yet to come. As a result, US housing market activity will remain muted, causing a rise in employment.


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