Although economic activity in the second quarter surprised analysts, with the economy growing at a 2.5% annualized rate, this momentum could be subdued by several major headwinds ahead.
For starters, uncertainty around the Fed's exact plans for tapering mortgage bond and Treasury purchases lingers, Fannie Mae said in its latest housing update.
"With regard to housing, all eyes are now turned toward the Federal Reserve, which is expected to begin scaling back its asset purchase program this week," said Fannie Mae chief economist Doug Duncan.
He added, “Mortgage rates have increased more than 100 basis points since early May, and we anticipate that trend to continue, albeit gradually, during the next year. Despite the rise in mortgage rates, we expect the housing recovery to continue, with the mortgage market shifting away from refinance activity and more toward purchase activity.”
The majority of the market expects the Federal Open Market Committee to announce a start to QE tapering at a meeting this week, with plans to end purchases by mid-2014.
"We still believe that an actual increase in the federal funds rate is unlikely before mid-2015, given the Fed’s rate guidance and our forecast of the unemployment rate and inflation," Duncan said.
He continued, "We expect market volatility to remain somewhat elevated as a result of the uncertainty regarding the leadership and the next mix of the FOMC members."
On a similar note, Nationwide Insurance chief economist David Berson pointed out that interest rates fluctuated over the past month in response to weaker employment data and greater certainty that the central bank would begin to taper QE in the near-term.
"Over the course of the month, and into early September, the up-moves dominated and yields are higher than a month ago," Berson stated. "Very short-term rates remain anchored by the Fed’s zero interest rate policy."
Consequently, housing is feeling the pain of rising interest rates.
The FOMC minutes from July pointed out that members expressed concerns that the rise in mortgage rates could potentially harm the housing market.
Since then, long-term interest rates are moving higher and are expected to remain volatile for some time.
For instance, the yield on 30-year, fixed-rate mortgages should trend up to 5.3% by the end of 2014 from the rate in early September of roughly 4.5% — 120 basis points higher than its recent trough in May, Fannie Mae pointed out.
Recent housing indicators have shown signs of softening from the rise in mortgage rates.
"Leading indicators of housing activity were mostly down in response to higher mortgage rates — without the offset of a stronger job market," Berson pointed out.
Single-family housing starts fell in July for the third time over the past five months, remaining more than 5% below February’s pace.
Additionally, pending home sales fell moderately for a second consecutive month, suggesting that existing home sales will pull back in the coming months.
"This is consistent with our expectation that the rise in rates provided a strong incentive to accelerate the place of closings and thus pulled forward some sales," Duncan said.
Meanwhile, affordability — while remaining historically high — is becoming an issue for some potential homebuyers, especially first-time homebuyers.
Factors contributing to the lull in affordability include the strain on credit availability amid continuing rising home prices and anemic income growth.
Furthermore, the surge in mortgage rates has led to a significant decline in refinance demand, with refinance applications plunging more than 60% since early May, according to Fannie Mae.
Given the expectation that rates will continue to trend higher, many market experts believe the refinance boom has peaked.
"Anticipated declines in refinance originations suggest that mortgage industry employment, which has trended up since reaching bottom in early 2012, will likely pull back in coming months," Fannie Mae analysts concluded.
