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Best case scenario: Rates drift lower from current levels

Worst case: Rates rise further

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It seems that move-up and luxury builders are less susceptible to the consequences of higher mortgage rates than an entry-level buyer would be, according to Sterne Agee analyst Jay McCanless. Repeat homebuyers should have equity already built up from their previous homes, reducing monthly payments and improving affordability.

In an analyst report from McCanless, he estimates the worst case scenario for mortgage rates as of now is that they advance to the high 5% to low 6% range which approximates the 265 basis points average mortgage rate increase.

The New York Fed's Liberty Street Economics unit put out a piece that detailed the fifteen largest yield increases in the history of the 10-year Treasury note.

According to McCanless, the best-case bullish interpretation says that rates drift lower from current levels. Back in 2003, the 10-year yield peaked after two months, then slowly drifted lower over the following 18 months.

Since May 3, 2013, the 10-year yield has increased from 1.63% to as high as 2.72% on July 5 and August 1. If the 2003 example is any indicator, then the worst may be over for housing stocks assuming incrementally lower 10-year rates and lower mortgage rates strengthens the number of qualified buyers.

"Based on the data, we believe the best case scenario is rates (mortgage and 10-year) have peaked and will slowly move lower," McCanless said.

On the flip side, if the worst-case scenario occurs, rates will rise further. “We believe bears will assume current yields move higher than the 119 basis points change thus far,” said McCanless. The range of yield increases in the Fed’s sample stretches from 119 basis points to 565 basis points, with an average of 235 basis points.

McCanless noted that it is important to remember that rising spreads are positive for mortgage originators and negative for builders. Since peaking at $18.7 billion in the middle of December 2012, the 4-week moving average of the Federal Reserve’s weekly MBS purchases has dropped 17.5% to $15.5 billion by the end of July.

During that same time frame, the spread between 10-year Treasury rates and the national average 30-year mortgage rates has risen approximately 14% to 200 basis points from 175 basis points.

“We anticipate higher spreads are positive for originators, and we believe the higher spreads, rising home prices and seasonality are reasons for softer housing trends versus spring 2013’s activity. We also believe taper talk is a headline risk for builders, but the business risk from higher spreads appears to be the real concern,” said McCanless.

Competitive threats are nonexistent and builders are pushing prices up and growing margins at lower volumes than was originally thought possibility. Until selling conditions show signs of a negative shift, McCanless claims his top picks — Ryland Group (RYL), Meritage Homes Corp (MTH) and D.R. Horton (DHI) — are undervalued at current levels.

 

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