Investors Fear Fed Will Increase Rates Too Much Too Fast

As the Federal Open Market Committee meets this week to increase interest rates for the 17th consecutive meeting, 6 in 10 investors say they think the Fed will increase interest rates too much too fast, leading to a recession, according to the June UBS/Gallup Index of Investor Optimism. This belief may be one reason why investor optimism has continued to decline and now stands at its lowest point this year. Rising interest rates may also help explain why investors have such a dim view of the residential real estate market nationwide.

In June, investor optimism reached its lowest point this year, as the Index of Investor Optimism fell to 58, down from 64 in May. The Index is down 35 points from January’s 93, falling 13 points in February and 16 points in April before experiencing a further 6-point decline in June. The Index had a baseline score of 124 when it was launched in October 1996.

The Personal Dimension is essentially unchanged at 57, compared with 56 in May. In sharp contrast, the Economic Dimension fell seven points in June and now stands at 1 — suggesting that investors, as a whole, are virtually neutral (neither optimistic nor pessimistic) about the course of the U.S. economy over the next 12 months.

Nine in 10 investors (94%) say the price of energy, including gas and oil, is hurting the investment climate a lot (73%) or a little (19%). Second among investor concerns are the outsourcing of jobs to foreign countries (80% say it is hurting the investment climate) and the federal budget deficit (79%). About three in four investors also say they worry about the current situation in Iraq (76%), questionable accounting practices (73%), and worries about inflation (72%).

Half of investors rate economic conditions in today’s residential real estate market nationwide as good (45%) or excellent (5%). More importantly, however, almost two in three investors (63%) say conditions in the housing market are getting worse, rather than getting better (29%).

When asked about conditions in their local communities’ residential real estate market, investors are a little more positive, with 56% saying they are good (39%) or excellent (17%). And, they are evenly split about the future direction of their local real estate markets, with 48% saying things are getting worse and 46% saying they are getting better.

It is not surprising that investors are more pessimistic about the national real estate market than they are about conditions in their local communities. Everyone has heard about housing prices soaring in various super-heated markets and they have heard about the more recent slowdown in those markets. In addition, most investors are better able to evaluate their local real estate markets than they are the overall real estate market nationwide.

Of course, the big question for housing and the U.S. economy is not whether the real estate market will slow — that has clearly happened. Rather, the issue is whether the housing market will experience a “soft landing” or something much worse. A “soft landing” could slow the overall economy not only as real estate-related jobs — construction, home appliances, mortgage origination — disappear, but also, as a lack of house price appreciation leads consumers to borrow less on their home equity and reduce overall spending. On the other hand, a sharp drop in housing activity could lead to distress sales and severe consumer credit problems, not to mention the loss of many jobs.

Right now, it is not clear what the ultimate fate of the residential real markets in the United States will be in coming months. About a third of investors expect housing prices to decline at a moderate rate (28%) or a rapid rate (4%) over the next 12 months. About a third expects housing prices to increase moderately (27%) or rapidly (8%), while the remaining third expects prices to be flat. Of course, any drop in housing prices could be serious given the financing techniques of recent years, particularly if the half of investors who believe conditions in their local real estate markets are getting worse turn out to be right.

Still, new Fed Chairman Ben Bernanke and prior Fed Chairman Alan Greenspan argue that housing will experience a “soft landing.” If they are correct, then maybe this week’s increase in interest rates will turn out to be OK. If not, then even the third of investors who rate Bernanke’s job performance so far as good (32%) or excellent (2%) may have to reconsider. More importantly, the 6 in 10 investors who say the Fed will “overshoot” and tighten too much may turn out to be all too prescient.