“A one percent rise in bond yields will produce the largest bear market in bonds that we have seen since 1980 to 1981.”
Ray Dalio, Founder of Bridgewater Associates (the largest global hedge fund in the world) said this last week in Davos.
I agree with the wise billionaire.
Our economy is interconnected. One piece affects all others, and right now Fed policy, fiscal spending, and the tax reforms are creating a perfect storm of economic destruction.
Bonds are just one asset class in the path of this monetary monsoon.
The real estate market is in a position to get utterly demolished.
How the Dominoes Fall
Promises of higher government spending coupled with lower tax revenues have caused the dollar index (DYX) to drop approximately 15% over the past 14 months. Higher budget deficits equal lower dollar value.
This can have hidden costs.
For example, say you made a 12% return in the stock market during the last 14 months. When we take into account the fact that the dollar lost 15% of its purchasing power during this time period you’ve actually lost 3%.
USD value also impacts the demand for US bonds.
If the buyers of US bonds–primarily foreign governments–anticipate the US dollar losing value (which would cause inflation) then they will be less willing to buy bonds.
China, the largest holder of US debt, has already significantly slowed down its purchasing of US Treasury bonds.
Beijing-based Dagong Global recently downgraded the US to BBB+, claiming the US is a bigger debt risk than Russia and Botswana. The firm explicitly stated that President Trump’s tax plan was a key reason for the downgrade.
The Gold market, which just hit an 18-month high, also suggests that inflation is on the immediate horizon.
Inflation would further dampen the demand for US bonds. Why loan the US money when the principal will be worth less than the original amount when it’s paid back?
A drop in demand has a direct impact on bond yields.
Decreased demand and the increased inflation risk makes it necessary to pay a higher rate of return–known as the coupon rate–in order to entice bond buyers. Higher bond yields are needed to compensate for the loss of principal caused by inflation.
Bond yields influence mortgage rates; the two are positively correlated.
Banks loan money based on alternative investments and risk. Mortgage rates have been historically low because bond yields have been historically low.
It’s like this: A bank has 2 options. Option 1: Buy a 10-year Treasury Bond at 2.5% interest, or Option 2: Loan out the money to a home buyer at 3.75% interest with a calculatedly higher risk.
So, if bond yields move up (because the bonds have become riskier) mortgage rates also move up accordingly.
Mortgage rates affect the purchasing power of real estate buyers. The higher your mortgage rate, the higher your monthly payment, the lower the loan amount you will be able to afford.
To recap, this is how the dominoes fall:
Weak USD > inflation > depressed demand for US bonds > increased bond yields > increased mortgage rates > higher monthly payments > smaller loans
What does all this mean for real estate prices?
Look out below.
-Allen A Garzone II, Garzone Real Estate, Inc, Boston Real Estate Agent