Editor’s note: The real estate industry is heading for big change in 2005. Experts once again are predicting slower home sales and easing price appreciation due to an anticipated rise in interest rates. In this Inman News forecast series, we attempt to get a clear picture of the industry next year, including what we can expect from housing numbers, who the industry should be watching and what the best and worst-case scenarios might be for housing in 2005. (See Part 2: Best-case scenario for housing next year; Part 3: Worst-case scenario for housing next yearPart 4: What will happen in 2005? Part 5: 15 people to watch in 2005; and Part 6: Inman News Readers 2005 Real Estate Forecast.)

In 2005, interest rates have nowhere to go but up.

Economists, lenders, mortgage brokers and others involved in the housing industry can at least agree on that. But they expect the rise to be gradual and don’t believe it will drastically impact the nation’s housing market.

By the end of 2005, most expect mortgage rates to be in the range of 6.5 percent to 7 percent.

“They’re not going to be as good as they had been in the past, but not disastrous,” said James Barth, senior fellow at the Milken Institute and finance professor at Auburn University.

Looming over mortgage rate movement is the Federal Reserve’s stance on monetary policy and the state of the bond market.

Since June, the Federal Reserve’s Open Market Committee has raised its target for the federal funds rate by 25 basis points five times, bringing it to 2.25 percent. The federal funds target rate is what banks charge each other overnight. It has no direct impact on mortgage rates or the bond market, but it can alter them indirectly. A change in the federal funds rate, for example, is likely to change the prime rate, the rate banks charge their best corporate customers. That’s generally about three percentage points above the federal funds rate.

From there, any lines of credit tied to the prime rate rise as well. The yields on short-term Treasury bills generally move with changes in the federal funds rate.

Since rates on 30-year fixed-rate mortgages tend to move closely with the 10-year Treasury bonds, any potential increase in the rate of that benchmark bond is likely to drive up mortgage rates as well. And with the overall continuing decline of the dollar against other currencies, it’s likely the 10-year Treasury bond will increase regardless of what the Fed does, said Christopher Cagan, director of research and analytics for First American Real Estate Solutions.

Economic experts already agree the dollar is overvalued and that the United States’ so-called twin deficits are largely responsible for the dollar’s continuing decline, Cagan said. The twin deficits are the budget deficit and the trade deficit, each running at about $500 billion annually.

With the government spending more than it takes in with taxes, it must borrow money in the form of government bonds, often purchased by foreign investors.

The trade deficit, caused by Americans buying many more foreign goods than the country exports, leaves foreigners with American dollars. The American economy needs that money so it can continue purchasing foreign goods. Many foreign investors have been content to invest those dollars in American financial markets – stocks, bonds and Treasury bills, which have largely been considered a safe haven investment, Cagan said.

With the dollar’s value sliding because of the twin deficits, foreign investors buying Treasury bills are seeing their interest gains wiped out because of the lower currency conversion. That means foreign investors, whether individuals or central banks, will begin exerting pressure on the market to increase the interest rate on bonds to make up for the dollar’s sliding value. As the Treasury rates rise in response to that, mortgage rates will follow.

The market is pressured from foreigners owning so much U.S. debt. Chinese and Japanese investors alone own about 36 percent of Treasury bills, Cagan said.

Pat Stone, vice chairman of Metrocities Mortgage, said he’s concerned that the country’s debt will remain attractive to those foreign investors only if interest rates are higher.

“You’re going to have to raise the return on bonds to get foreign investors to buy them,” Stone said.

But because foreigners don’t own all U.S. Treasury bills, their rate won’t increase at the same pace as the dollar’s decline, Cagan said. And since 30-year fixed-rate mortgages deal with a longer time frame than Treasury bonds, their rate of increase will be slower.

Still, mortgage rates will go up. If the dollar’s value slides another 10 percent against other key currencies such as the euro and British pound, mortgage rates could hit 7.5 percent to 8 percent next year, Cagan said. Using the more moderate prediction that the dollar will only slide about another 5 percent, mortgage rates should be closer to the 6.5 percent to 7 percent range by the end of 2005.

Cagan’s prediction also considers anticipated short-term rate hikes by the Fed. Most observers expect the central bank to move its federal funds rate to what it considers a neutral monetary policy.

No one knows for sure what the Fed considers to be a neutral policy, but it is likely between 2.5 percent and 3 percent, according to Delores Conway, director of the Casden forecast for the USC Lusk Center for Real Estate. Doug Duncan, chief economist with the Mortgage Bankers Association, expects the Fed’s target rate at 3 percent by the end of the next year.

Yet despite telegraphing its intentions through its policy statements, the Fed’s next move is never a given.

“With the Fed, it’s always a little difficult to tell what they will do,” Barth said.

For the most part, though, experts agree that three or four more 25 basis point increases throughout next year is a likely course of action for the Fed.

“I think the outlook for interest rates is slow and steady (increase), which is good,” Conway said.

A slow increase should mean only a gradual Fed-related rise in mortgage rates, which fares well for the housing market. While home sales likely won’t be as robust in 2005 as they were in 2004, most experts still predict an overall strong market. David Lereah, chief economist with the National Association of Realtors, said the nation’s housing supply is lean, demand is strong and households can still afford to buy homes.

“We’re looking at a pretty good year,” Lereah said. “Obviously we’re going to have some upward pressure on mortgage rates because of the Federal Reserve.”

Lereah expects mortgage rates to be around 6.9 percent by the end of next year.

The California Association of Realtors’ prediction for mortgage rates next year is around 6.6 percent. The MBA is forecasting about 6.25 percent.

Even the high end of such predictions – 7 percent – would be low by historical standards, Cagan points out.

“Yet there are people who would say, ‘Don’t say that, don’t say that. You’re going to ruin everything for everybody,'” he said.

That’s not likely if rates stay as low as generally predicted. Variables such as a rapid decline in the dollar or a sharp jump in oil prices could push rates higher than expected, but ultimately the view of next year’s mortgage rates appears to be one of optimism with a touch of hope.

Pava Leyrer, president of Heritage National Mortgage Corp., summed it up: “I just hope they stay reasonable.”

Send tips or a Letter to the Editor to samantha@inman.com or call (510) 658-9252, ext. 140.

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