The Albatross or the Canary

With rate cuts possibly on the horizon, many assume cheaper borrowing signals smooth sailing ahead. But did the Fed find the albatross we’re hoping for, or is this more of a canary in the coal mine? History shows it’s not always that simple. While lower rates can boost savings and cash flow, past cuts have often signaled economic trouble ahead. Understanding why the Fed adjusts rates—and what happens next—is key, especially since today’s methods differ from those of earlier decades. Meanwhile, our local real estate market is cooling after a slower start to 2024. Homes are taking longer to sell, and average list prices are down 8% from last year, indicating sellers are adjusting to buyers’ affordability concerns. While this reflects affordability challenges more than a price crash, it still marks a market shift as supply rises and demand softens. Are we headed for steady winds or stormy seas?

The Skim:

1. Rate Cuts: The Albatross or the Canary

2. Demand — Staying on Trend

3. Supply — Stable at Lower Prices

Are Rate Cuts a Good Thing?

Lower interest rates are often seen as good news for consumers. Most people have long-term debt, like mortgages, student loans, and car loans, which are all influenced by the prevailing rates in the market. Like consumers, companies also benefit from lower rates because they often rely on short-term debt tied to rates like the prime rate or on longer-term debt based on the Treasury curve. When interest rates drop, both consumers and companies tend to save money, which can boost cash flow and increase profits. So, why would we ever ask, "Are rate cuts a good sign?"

To answer this, we first need to understand the Federal Reserve’s role in setting interest rates and look at what typically happens after rate cuts. The Fed has a unique mandate among central banks: it must balance two goals—promoting full employment and keeping inflation under control. This dual mandate, unlike many central banks that focus solely on inflation, adds complexity when deciding if rate cuts are a positive sign.

In recent years, the Fed has focused on controlling inflation, aiming to bring it back to around 2% per year. This shift happened after a decade of low rates following the Great Financial Crisis, tax cuts before COVID, and massive cash infusions during the pandemic lockdowns. These factors created a feedback loop: consumers had extra cash to spend, and as Baby Boomers retired, the labor force shrank. Companies had to pay higher wages to attract workers, which led to higher prices to maintain profit margins. As wages increased, more money circulated in the economy, driving up inflation.

The Fed’s main tool to combat inflation is raising short-term interest rates. Higher rates make borrowing more expensive, which can slow down spending by both consumers and companies, easing demand and helping to control inflation. This is why rates rose so quickly starting in December 2021—it was one of the fastest rate increases in history. Since July 2023, the Fed has kept rates steady, watching to see if further hikes are needed to curb inflation or if there’s room to lower them to protect the job market. Recently, the Fed hinted that the next move might be to cut rates, which excited the market and pushed stocks and other riskier assets to all-time highs. But the question remains: Are rate cuts really a good thing, or is the market being overly optimistic?

Over the past 40 years, there have been only four major instances when interest rates peaked: June 1984, March 1989, October 2000, and July 2007. Let’s see what happened in the stock market after these peaks:

• From June 1984 through December 1984, the stock market was relatively flat, then continued its upward trend.

• In March 1989, the market rallied lightly until the summer of 1990, when there was a 15% drop in stocks before the rally resumed.

• October 2000 marked the peak of the NASDAQ bubble, leading to a sharp sell-off that lasted over two years.

• July 2007 was just before the Great Financial Crisis, and the market experienced extreme turmoil from then until 2010.

The first two periods don’t seem too concerning, but the more recent two suggest that tough times might follow rate cuts. Why is there such a difference? Before 2000, the Fed used a "corridor system," setting a target rate while allowing market forces to influence the actual rate. This led to more rate volatility but also let free market principles play a role. After 2000, the Fed began using tools to reduce volatility, minimizing the influence of market forces. Some believe that this current method of rate control can lead to misallocations of capital—like people buying multiple homes without enough income before the Great Financial Crisis—which can later "snap" and cause bigger economic problems.

In the end, if we’re asking whether rate cuts are "good," the answer is, "maybe." Let’s hope that any misallocations of capital don’t come back to haunt us as the Fed continues to fine-tune rates.

Demand — Staying on Trend

Supply — Stable at Lower Prices

Let’s check in on our trusty table summarizing the Denver metro housing market within a 10-mile radius of downtown Denver:

The market started 2024 slightly slower than in 2023, and this trend accelerated after April. During the first third of the year, the median Days on Market (DOM) were 2-3 days longer compared to last year. By June, it was four days longer, and in July, there was a more noticeable shift with the median DOM increasing by eight days. While a median DOM of 12 days still indicates a relatively tight and healthy market, it took some time for sellers to adjust their pricing expectations, while buyers tried to find the floor for acceptable prices. The average list price in our market area is now 8% lower than a year ago, reflecting a cooling from the frothy conditions of 2022-2023. This doesn’t mean that home prices have dropped by 8%, but rather that sellers are listing at more affordable prices, likely due to affordability concerns rather than a significant loss in equity.

Our data shows that pending and sold activity remains consistent, indicating that the slowdown is likely due to increased inventory rather than a lack of buyers. Assuming absorption rates continue to follow the trend from 2023, we expect that DOM will keep rising. Last year, there were 4,315 closings from August to October, and right now, there are 4,337 homes on the market. Even though not all these homes will sell, it will still take at least two months to absorb this supply, which suggests the current median DOM of 12 days is too low.

It’s interesting to note the significant drop in the average list price from June to July. In June 2024, list prices were only down 3% compared to the previous year, so it was surprising to see the final July data show an 8% decline. This drop was seen across both detached and attached properties, with a slightly bigger contribution from homes priced below the median transaction price of $800k. Although our data isn’t perfect in this regard, it suggests that affordability remains a challenge for buyers, even with some easing of mortgage rates (and expectations of the Fed cutting rates this fall).