It has been a rough three years. Most Americans have lost a lot of their financial security. Small investors are abandoning the stock market. The assumption that homeownership is a great investment is out the window for now. Regardless of whether home prices resume their upward climb, Americans may choose to be more conservative in how much house they choose to buy. These are perfectly rational choices to make given recent history. However, people should think twice before choosing to be long-term renters. Why? First, the Federal Government has pushed interest rates to multi decade lows. The Federal Reserve is actively buying bonds out the yield curve in order to push borrowing costs down even further. Home prices had adjusted sharply downward and these two things combined have made homeownership more affordable. But that is not the prime reason to own a house today.
Here is my fear. I fear that the people who were really hurt in this stock market and housing bust will end up getting hammered again. Choosing not to invest in stocks may be wise. However, anyone who piles into bonds at this point risks really losing a lot of value when rates rise again. Note this NYT piece about a potential bond bubble, like the dot.com bubble or the housing bubble. Bubbles burst. If you are buying bonds you are basically betting that either the US is going into Japanese style long-term stagnation or that you can outsmart Wall Street and sell the bonds again before they do. That is playing with a loaded gun. When they sell their bonds, you will lose.
From the article:
Those who are now crowding into bonds and bond funds are courting disaster. The last time interest rates on Treasury bonds were as low as they are today was in 1955. The subsequent 10-year annual return to bonds was 1.9%, or just slightly above inflation, and the 30-year annual return was 4.6% per year, less than the rate of inflation.
Furthermore, the possibility of substantial capital losses on bonds looms large. If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?
This does not project what will happen if we move into a dollar devaluation scenario or if buyers quit purchasing the mass issuance of government debt. Rates can move much more dramatically.
Renting is a pretty good deal right now and may be for several years. But, if inflation comes, renters will not be spared. Many economists, and I trust the bloggers the most, believe we will suffer a period of deflationary pressures and then the debt burden on the US Government will become so large and the structural deficits so uncontrollable that there will effectively be a devaluation of the dollar through money supply creation and inflation in prices. If this happens, it will drive up interest rates as well as home prices. Rents will follow. If, on the other hand, the deficit is not as large as expected, that will primarily result from an economy that is stronger than expected and therefore has driven tax revenues up. In either case, interest rates rise. In either case, bond investors take capital losses from today’s levels and the price of either home ownership or rent goes up, perhaps dramatically.
So what to do? If you are in that group that was already in bond funds prior to the last few weeks, you have some profit built-in. For those investing in bonds today, beware. The math does not work in your favor unless economic growth stays down long-term and the government can negotiate through its high debt levels without the markets reacting. To me those combined scenarios are low probability. Not impossible, but low probability.
From a housing standpoint, if you are one that currently does not own and has lost confidence in home prices, and would be a long-term occupant in your particular circumstances, think about the range of possibilities. What if inflation was 5% per year, mortgage rates went back to the 6-8% historical range, and the cost of your rent (probably artificially low in most places right now, went up 10% then 5% per year. Then five years from now you were looking at buying a house. How much would your payment be compared to if you bought today? How much would your future rent be compared to a payment locked in at today’s low interest rates. How much would having your long term cost locked be worth to you in a day of fiat currencies? Try to assign probabilities to the different scenarios and make your decisions. Maybe it is still worth staying flexible. Just know the risks.
Don’t just go with the flow.