Housing Recovery Is a Confidence Game

NEW YORK ( TheStreet) -- The housing recovery is showing signs of strain as rising rates, higher home prices and a shortage of homes for sale has dampened homebuyer enthusiasm.

Bank of America Merrill Lynch economist Ethan Harris noted in a report Friday that a number of housing indicators have weakened recently including housing starts, mortgage applications and new-home sales.

This is worrying, especially if interest rates rise further. As Harris put it, "While borrowing costs remain very low by historic standards, it is not clear whether the market is ready to come off 'life support' yet."

Bank of America Merrill Lynch's economists have so far maintained that the recent rise in interest rates would not derail the recovery as homebuyers continue to expect prices to go higher. That momentum from higher price expectations should offset the impact of rising rates.

The economists expect home prices to rise 12% in 2013 and then expect gains to moderate to about 6% in 2014.

But a collapse in home prices is unlikely, according to Harris, for three reasons. First, home prices are fairly "sticky" because buyers are slow to change their expectations in response to evolving trends.

Secondly, the housing market is not as interest-rate sensitive today because there is significant pent-up demand from homeowners who exited in the downturn.

Plus in the current credit market, it is the availability of credit rather than interest rates that are influencing the decision of buyers, particularly at the lower end. Basically, the buyers who are sensitive to interest rates are weeded out by the tough credit conditions.

Lastly, Harris cited academic models that have found that interest rates have a smaller impact on home prices.

Still, home prices respond with a lag to weakening activity so it might make more sense to study more timely demand data such as starts and permits and mortgage applications as well as the Michigan survey on home price expectations.

He added that if expectations of home prices continue to drop, BofA will cut its forecast.

In sum, the housing recovery right now rests on homebuyer confidence. Given the state of the economy now, the foundation is still weak.

-- Written by Shanthi Bharatwaj in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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