The Federal Reserve opted to hold interest rates steady at their policy meeting in September, but Fed Chairman Janet Yellen signaled that a rate hike could come by the end of this year. Also weighing in was San Francisco Federal Reserve Bank president, John Williams, who told the financial press that the US economy is strong enough to handle an interest rate increase and that continued inaction could do more harm than good to the economic recovery. Most analysts expect a rate hike to happen at the year-end Fed policy meeting rather than at the next meeting in November due to the upcoming presidential election.
The stock market appears already braced for a rate increase; major stock indices were down more than one percent in the week leading up to the Fed policy meeting. Some traders conjectured that the stock market sell-off was a major reason that the rate hike was delayed. According to Deutsche Bank analysts, interest rate hikes frequently, which make stocks more volatile in the short-term, and associates with stagnant equity returns in a 12-24 month period following the initial rate hike. These analysts also noted that the stock market impact becomes even more pronounced later in a rate hike cycle.
CNBC commented that fixed income investments also become more volatile when a rate hike is anticipated, but differ from stocks in that the impact is felt faster. Bond yields change direction almost immediately when the Fed begins a cycle of interest rate hikes. In addition, Charles Schwab strategists pointed to a flattening yield curve, the result of yields between longer- and shorter-term bonds moving closer together in response to a rate hike. In such a scenario, higher-yield bonds are often the best-performing fixed income investments.
The housing market has benefited significantly from a prolonged period of unusually low interest rates, but most economists believe that a rate hike isn’t likely to slow housing market growth since the housing recovery has been supported by steady economic expansion and job growth in addition to modest mortgage rates. Also, mortgage rates tend to move in tandem with 10-year Treasury note yields, and the yields on Treasuries don’t change as dramatically as yields on longer-term bonds when rates increase. Fannie Mae’s chief economist anticipates a minimal impact on Treasury yields from a modest interest rate hike and believes that a rate increase is already priced in by financial markets. He noted as well that a limited housing inventory will have a greater impact on housing markets than any rate hike since supply constraints continue to drive up home prices in many parts of the US.
Although many investors assume that banks celebrate higher interest rates since interest income from new loans rises, the overall impact is ambiguous since bank funding costs also rise. Most banks finance loans and other investments by issuing debt, primarily in the form of deposits. Researchers at the St. Louis Fed Bank indicated that the key to understanding the relationship between market interest rates and bank profits is that banks “lend long and borrow short.” That is, bank loans typically have longer average terms to maturity than bank deposits. As a result, when interest rates climb, bank funding costs rise more quickly than interest income. The net effect is bank profit margins often move in the opposite direction from market interest rates in the short-term.
A major difference between bank loans and the loans held by mortgage pool funds is that the latter loans usually have much shorter terms to maturity. Maturities for mortgage pool fund loans generally range from one to three years. Because of very short maturities, the value of these loans doesn’t change appreciably even when market interest rates gradually rise. In contrast, the value of long-term debt often falls significantly when interest rates spike. For example, academic studies have shown that every one percent increase in interest rates may cause a bond with 15 years remaining to maturity to lose as much as 15% of its value.
The value of the loans held in a mortgage pool is only minimally affected because capital can be redeployed quickly into new higher yielding assets when interest rates rise. Mortgage pool fund loans are already at the higher-yielding end of the fixed-income spectrum due to more risk. Fund managers mitigate this loan risk by diversifying their portfolios across a variety of maturity dates, property types and geographies. The fix-and-flip loans funded by mortgage pools typically have interest rates varying between 10 and 15 percent, which is more than double current interest rates on 30-year fixed rate bank mortgages averaging around four percent. The higher interest rates on fix-and-flip loans translate into superior returns for mortgage pool fund subscribers. Many mortgage pool funds are currently delivering 8 to 9 percent returns to their investors.
To the extent that rising interest rates also signal a strengthening economy, a rate hike benefits mortgage pool funds by enhancing lending opportunities and facilitating loan portfolio growth. Steadily rising home prices have created a robust market for fix-and-flip investing, with industry ROIs and gross profits approaching near record levels. According to RealtyTrac, the average gross profit on a house flipping investment hit $57,000 in the second quarter of 2016, the highest gross profits in 16 years. House flipping ROI peaked at 48.8 percent and was up more than 100 basis points from ROI averaging 47.5 percent one year earlier. These robust returns are stimulating demand for loans in what has become an enormous fix-and-flip market. According to online mortgage marketplace LendingHome, house flipping represents a $30 billion annual origination opportunity.
Due to their ability to redeploy the capital from maturing loans into new higher-yielding loans more quickly than banks, mortgage pool funds may be better positioned than other fixed income investments to deliver healthy returns when the Federal Reserve Bank begins a cycle of rising interest rates. In addition, a robust housing market, supported by employment expansion and steady economic growth, is enhancing business opportunities for fix-and-flip investors and fueling demand for mortgage pool lending.