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Acting as a deterrent to the surging hopes of a housing recovery, new home sales in July were reported to have dropped a sharp 13.4%. While the news affected the broader markets for a short span on Friday, the housing sector had to suffer a finish in the red owing to increasing concerns that the rising mortgage rates could slow down the housing recovery.

The SPDR S&P Homebuilders (XHB) lost 1.4% on Friday and shares of homebuilders such as Toll Brothers Inc. (TOL - Analyst Report), KB Home (KBH - Analyst Report), Lennar Corporation (LEN - Analyst Report), Hovnanian Enterprises Inc. (HOV - Snapshot Report), PulteGroup Inc. (PHM - Analyst Report) and D.R. Horton Inc.  (DHI - Analyst Report) sank between 2% and 4% on the announcement.

The U.S. Census Bureau reported on Friday, Aug 23, that sales of new single-family houses declined 13.4% to a seasonally adjusted annual rate of 394,000 in July. The July figure is much below June’s rate of 455,000, which was revised down from a previously reported 497,000. The July figure was also much below the median estimate of economists surveyed by Bloomberg. However, new home sales are still up 6.8% from the year-ago period.

The report also stated that the median sales price of new houses sold in July was $257,200. Moreover, housing inventory stood at 171,000 homes at the end of July, representing a supply of 5.2 months at the current sales rate.

In sharp contrast to weak new home sales data, sales of existing homes rose in July according to the data published by National Association of Realtors last week. Moreover, data published by the National Association of Home Builders (NAHB) in mid-August showed that housing starts across the U.S. rose 5.9% in July.

Since mid 2012, homebuilders have largely benefited from historically low interest rates, eventually leading to the sharp increase in home buying activity. With the recent improvement in economic conditions and the housing market in general, mortgage/interest rates have been edging upward to more normalized levels since May 2013. According to the Freddie Mac mortgage survey, the 30-year fixed mortgage rate has risen from 3.59% on May 23 to 4.58% as of Aug 23. In fact, mortgage interest rates are at the highest level in two years. As a result we found the share prices of most housing stocks hurtling down after having peaked in May. The better-than-expected earnings at most homebuilders in the last quarter also failed to prevent the share slide.

This has raised concerns among some analysts. High interest rates dilute the demand for new homes, as mortgage loans become expensive. Subsequently, this lowers a buyer’s purchasing power. Moreover, if the Federal Reserve scales back its current $85 billion bond buyback program and instead adopts a tighter monetary policy, as planned, interest rates may further shoot up. This in turn would lower revenues and profits of homebuilders.

However, another group of analysts believe that interest rates are still below historical levels despite the recent hike and housing is still very much affordable. Home prices have also started rising with market demand gaining momentum but supply remaining limited (both of existing and new homes). In fact, this group of analysts believe that rising home prices and thinning home inventories have created a sense of urgency among homebuyers to buy a house before prices or mortgage rates shoot up further.

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