Falling interest rates were the key support to housing demand and home builders until the middle of this year. The atmosphere in the nation's bond markets started to change dramatically as June drew to a close, and long-term interest rates lifted well off their cyclical lows. Such a shift naturally strikes terror into the hearts of home builders. But interest rate developments are not likely to seriously damage home buyer demand or cut into builder profits in the coming months.

Why the long rates?

The consequences of higher long-term rates depend largely on why they have risen. In this instance, the rise from the June lows primarily reflects upgrades in economic outlook, downgrades in the threat of price deflation, and statements by the Federal Reserve that unconventional policy weapons will not be used to force long-term rates down.

Thus, the recent pressure under long rates actually reflects brighter views by both the Federal Reserve and the investment community. If expectations are borne out, growth in income and employment will bolster housing demand, even as higher rates constrain demand. The net effect will be main-tenance of very good demand for homes.

ARM, an absorber

The shift in bond market psychology sent Treasury bond yields up sharply, but the rise in long-term mortgage rates was much less dramatic. Narrowing of the mortgage-Treasury yield spread normally occurs in an environment of rising rates as investors reassess the market value of the prepayment option in home mortgages, and that mechanism is playing out again.

Another welcome feature of mortgage markets is the presence of adjustable-rate mortgages (ARMs) that can keep home buyers in the market when the traditional fixed-rate mortgage becomes either unattractive or downright unaffordable. Indeed, the competitive position of ARMs has improved dramatically and usage by home buyers has climbed as a result. Past history shows that ARMs serve as an effective "shock absorber" when rates rise and the yield structure steepens, and that mechanism was kicked into gear at the middle of the year.

Short-term commitments

Most home builders raise money for land development and construction by borrowing from depository institutions at interest rates that are tied to the bank prime rate. These days, the prime rate is set three percentage points above the federal funds rate that, in turn, is set by the Federal Reserve.

The Fed cut the federal funds rate by 5.5 percentage points between early 2001 and mid-2003; the bank prime rate wound up at a 45-year low of 4 percent. The Fed normally begins plotting increases in the funds rate as an economic expansion gains momentum, but this time really is different.

The Fed became concerned about the possibility of destructive price deflation (a la Japan) in the spring, and Chairman Greenspan will keep short-term rates extremely low until it's clear that economic growth has sopped up the considerable slack in the labor market. That means the bank prime--and the cost of builder financing--should be stable for many months.