Whether viewed by home sales (demand) or housing starts (supply), the U.S. housing market downshifted significantly during 2022.

Housing demand is driven by a number of factors, but perhaps chief among them is mortgage rates, as the key input into affordability. In turn, mortgage rates are impacted primarily by longer-term Treasury yields, especially that for the 10-year Treasury note. The combination of a short-term COVID-caused collapse in economic activity, the Federal Reserve’s lowering the federal funds rate to zero, and the Fed’s reinstituting its quantitative easing program brought the 10-year Treasury yield down to an all-time low of just over 0.50% in August 2020 – dragging yields on 30-year fixed-rate mortgages (FRMs) down to their lowest levels ever at 2.65% at the start of 2021.

Although interest rates started to move modestly higher in 2021 and into 2022, mortgage rates remained at historically low levels, starting 2022 at around 3.22%. These low mortgage rates, combined with a spurt in economic growth and the ability of many workers to do their jobs remotely, pushed housing demand – and thus home sales – up sharply during this period.

But with the Fed starting to tighten monetary policy in the first quarter of last year, mortgage rates climbed sharply. By the end of 2022, FRM rates had climbed to 6.42% (although this figure was down a bit from last year’s high of 7.08%). The year-end rate was the highest since August 2008, while the peak rate last year was the highest since July 2001 – essentially generational highs for mortgage rates. On top of Fed tightening, mortgage rates climbed relative to Treasury rates, with the mortgage-Treasury spread widening to around 300 basis points (bps) late last year. While this spread is often volatile, it typically rises as the economy approaches recessions (and peaks during downturns), presumably as fears of mortgage credit risk peak. It averages a bit shy of 200 bps.

This combination caused FRM rates to rise by more in 2022 than in any year since 1981, when Fed Chair Paul Volcker tightened monetary policy by record amounts to fight high and intractable inflation.

Little wonder, then, that home sales dropped sharply last year. (Note that data are only though November, although it is unlikely that December will change these results – if anything, they are likely to worsen.) From their peak in January, by November new home sales had plummeted by 23%. At their bottom for the year (in July), the annualized sales pace of 543,000 units was the lowest since March 2016. Existing home sales, the larger component of the home sales market, fell by 37% from January to November (also the low for the year). The annualized pace of sales for November barely exceeded the COVID-low. And excluding the brief COVID hit, existing sales were lower than at any time since November 2010, when the market was recovering from the housing bust.

The sharp drop in home sales finally caused house prices to weaken over the second half of last year. After the fastest pace of gains ever in 2021 (up by 16.8% for the FHFA House Price Index, which tracks repeat sales), price changes flattened out over the last five months of 2022 for which there is data (through October). From a year earlier, increases in house values fell almost in half – from over 19% in February to “only” nearly 10% in October, and the 12-month gain is likely to be substantially lower when the November and December data are released in coming months.

But given the large decline in home sales, why didn’t house price gains cool by more? Transaction prices depend upon both demand and supply, and the supply of homes for sale has been historically low. The National Association of Realtors (NAR) provides data on the number of existing single-family homes for sale back to 1982. The median number over the period from 1982 to the present is 2.04 million units; but after seasonally adjusting the NAR data, the number was less than 1 million for the seven months ending in May 2022. And there were barely more than 1 million units for sale in each of the seven months ending in November. The entire post-COVID recession period has seen a paucity of existing homes for sale. New home inventories have increased despite the decline in housing starts last year. November single-family housing starts were down by a whopping 32% from a year earlier. Despite the inventory of new homes for sale rising sharply even with the drop in starts, the total number of homes (new plus existing) for sale remains extremely low.

The lack of homes for sale combined with strong demand as mortgage rates plummeted to record lows explains the sharp runup in house prices in 2020 and especially 2021. But the shift in the nexus of demand and supply has slowed house price gains significantly since then, with outright declines in some markets.

Will housing demand fall further in 2023? Will house price declines start to look like the 2007-10 housing bust period? Will mortgage delinquencies jump again?

All of these questions will be examined in next week’s part two of this look at the U.S. housing market.

David W. Berson joined Cumberland Advisors in November as Chief U.S. Economist following his retirement as Senior Vice President and Chief Economist at Nationwide Insurance. Contact him at feedback@cumber.com or 941-926-6279.

This article originally appeared on Sarasota Herald-Tribune: DAVID W. BERSON: A look back at troubles in the housing market in 2022