Buckle Up, We Could Be In For A Bumpy Ride In 2025 - 1.10.25

by Ryan Schoen , Principal Market Analyst

Quick Hit

Markets, household finances, and mortgage borrowers are in a precarious spot as risk across all three categories are elevated in the new year. ?The common thread between all three are rising borrowing costs on the back of concerning inflation projections. This year the new year resolution should focus around getting debt obligations under control before things get out of hand as the window of time to avoid larger problems is closing fast.

Key Points & Stats

1. The U.S. dollar has continued to strengthen, and the 10-year treasury yield has risen to the highest levels since April of last year indicating that the Fed has lost any semblance of control over the long end of the yield curve.
2. As of the third quarter of 2024, the total public debt as a percentage of gross domestic product stood at 120.7% ($35.5T in debt vs $29.4 in GDP). As rates continue to rise, so does the cost to service the debt.
3. Credit card and auto loan 30+ and 90+ delinquency rates are the highest that they have been at any point since the aftermath of the Great Recession. At the same time, we continue to see a strong trend higher in mortgage delinquencies as well.
4. The younger cohort of borrowers and those with less income are struggling to keep up with higher costs, in particular borrowers in the 30-39 age range are most concerning for the mortgage industry as these borrowers are prime age first-time homebuyer candidates. If they are saddled with debt that they can not keep current, then that could potentially limit a key portion of housing demand.
5. The typically reliable FICO score, which has been the north star for lenders to assess risk and a borrower's ability to repay may no longer be as reliable as it once was. FICO scores in all likelihood inflated post pandemic as cheap money flooded into the system. Americans who opened credit cards in 2021, 2022 and 2023 fell behind on bills quicker than they did on accounts originated in each of the previous five years despite the average U.S. FICO score hitting new all-time highs.
6. In a time when production levels are thin one would think that lenders would expand their credit box and product offerings. Yet, that has not been the case. According to the Mortgage Bankers Association, mortgage credit availability remains extremely tight with the overall index flatlining to levels not seen since 2012. This tightening is confirmed by the latest trends in origination characteristics.

A Precarious Spot for Markets

The new year has finally arrived, and it looks like we could be in for a bumpy ride ahead. Economic growth continues to come in stronger than expected, the decline observed around inflation continues to slow, and early indications point to the belief that government fiscal policy changes could boost inflation and deficits.

In response to these latest developments the U.S. dollar has continued to strengthen, and the 10-year treasury yield has risen to the highest levels since April of last year indicating that the Fed has lost any semblance of control over the long end of the yield curve.?

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Is this concerning you might ask? The answer to that question is yes, as any further strengthening in the dollar could quickly send 10-year yields to levels that don't just impact the mortgage market and rates but could also spark a U.S. and global debt spiral. The higher yields go, the higher the interest costs the government must pay on its borrowed funds and new bonds it issues. This makes it more expensive to service national debt and can put pressure on the government budget, potentially limiting funds available for programs and services. Unfortunately for the Fed, their blunt tools of rate cuts and balance sheet expansion leave them with extremely limited options to remedy the sticky situation that the U.S. economy finds itself in.

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Additionally, any drastic reduction in the fed funds rate in an attempt to get the longer end of the yield curve down could also have impacts outside of causing higher inflation. That other implication, which is likely to garner more attention in 2025, is what's known as the “yen carry trade”, in which investors borrow cheap money in yen, given their historically low and long running negative to ultra-low interest rates, and then invest the money in higher returning assets such as, you guessed it, U.S. treasuries and U.S. stocks. If the fed continues to cut short term rates at the same time that Japan is finally starting to raise interest rates those trades could quickly unravel leading to even more selling pressure in treasuries causing higher yields and potentially lower stock prices (see the correlation between the magnificent seven stocks and dollars to yen). After all Japan is by far the largest foreign owner of U.S. treasury securities.

As of the third quarter of 2024, the total public debt as a percentage of gross domestic product stood at 120.7% ($35.5T in debt vs $29.4 in GDP).

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A Precarious Spot for Households

The federal reserve and government aren't the only ones feeling the squeeze of higher borrowing costs. Household finances also face challenges in the year ahead.

According to the latest NY Fed Household Debt and Credit report, mortgage, auto, and credit card debt levels have reached new all-time highs. However, while overall debt levels receive the headlines, those aren't what is concerning. In fact, when placed into proper context the overall debt levels aren't very high in comparison to GDP, or “total income” earned from the production of goods and services produced in the U.S.

What truly deserves attention is the ability of households to service those debt levels and as things stand now households are struggling to meet those obligations. Credit card and auto loan 30+ and 90+ delinquency rates are the highest that they have been at any point since the aftermath of the Great Recession. At the same time, we continue to see a strong trend higher in mortgage delinquencies as well.

What appears to be going on is that the younger cohort of borrowers and those with less income are struggling to keep up with higher costs. Borrowers in the 30-39 age range are most concerning for the mortgage industry as these borrowers are prime age first-time homebuyer candidates. If they are saddled with debt that they can not keep current, then that could potentially limit a key portion of housing demand.

Diving deeper into the data, one possible thread that can be assumed is that the typically reliable FICO score, which has been the north star for lenders to assess risk and a borrower's ability to repay may no longer be as reliable as it once was. FICO scores in all likelihood inflated post pandemic as cheap money flooded into the system. Now that the tides have receded meaningfully those borrowers that saw their scores rise increasing their ability to borrower have been hit with a double whammy of higher prices and interest rates which has proven to be too much for many.

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As the WSJ and Brendan Coughlin puts it, "a traditionally calculated credit score “is not accounting for this abnormal environment,” he said. “It’s just looking at you.” In FICO’s view, the relationship between a given score and the likelihood of debt repayment changes alongside economic shifts, putting the onus on banks to evaluate how unusual swings translate to real-world risk. Americans who opened credit cards in 2021, 2022 and 2023 fell behind on bills quicker than they did on accounts originated in each of the previous five years.

A Precarious Spot for Mortgages

The clear risks outlined above for markets and household finances appears to also be shaping the risk appetite of mortgage lenders.

In a time when production levels are thin one would think that lenders would expand their credit box and product offerings. Yet, that has not been the case. According to the Mortgage Bankers Association, mortgage credit availability remains extremely tight with the overall index flatlining to levels not seen since 2012.

The trend in origination characteristics confirm the more stringent qualification standards as lenders tighten the spigot on homebuyers. FICO scores are rising, loan-to-values are dropping, and debt-to-income levels are surging as homebuyers take on more debt than ever to keep up with ballooning loan amounts on the back of rising home prices.

Markets with the highest costs to finance the purchase of a home are seeing debt-to-income levels rise the most. It's important to note that this data only goes through September, a time when 30-year fixed rate mortgages were declining. Once this data seasons and includes the further rise in home prices and recent surge in interest rates, we will see an even higher share of mortgage borrowers with DTI greater than 43%.

Given the reluctance of repeat homebuyers to enter the market and the need for borrowers to dip further into debt to buy a home it makes sense that we observe FHA and first-time homebuyers leading the way.?

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How things play out from here is anyone's guess, but one thing is for certain, whether it's markets, household finances, or mortgages nothing moves in a flat line. So which direction will these trends head in the new year?