A messy Brexit may agitate an already shaky housing market

The United Kingdom's stunning June 2016 vote to leave the European Union sent average mortgage rates in the U.S. tumbling 60 to 80 basis points (literally) overnight, as investors fled to the safety of the 10-year Treasury note that's the benchmark for mortgage interest rates.

U.K. and EU officials wrapped up negotiations on the terms for post-Brexit relations on Nov. 25, but that process was thrown into turmoil this week when U.K. Prime Minister Theresa May canceled a key Parliamentary vote to ratify the treaty — prompting her own party to call for a vote of no confidence. May ultimately prevailed in the challenge to her leadership, but the future of the Brexit deal remains uncertain.

With the March 29, 2019 Brexit deadline looming, it's unclear whether an agreement can be reached to avoid the more onerous conditions of EU treaties no longer applying to the U.K. and no framework to guide the Brexit transition.

Whatever the resolution to the Brexit ordeal, there will again be repercussions for the U.S. housing market. And with concerns already high in the mortgage and real estate industries about rising interest rates, inventory shortages and the threat of a housing bubble, the uncertainty overseas isn't guaranteed to deliver another Brexit bump for mortgages and real estate.

Here's a look at some potential scenarios for the mortgage and housing market depending on how Brexit plays out.

A messy Brexit could leave markets reacting much in the same way they did following the original Brexit referendum, when investors poured into the 10-year Treasury market and lower mortgage rates rekindled refinance activity.

"If that flight to safety occurs, we could see another Brexit benefit for the U.S. mortgage market this go around," said First American Chief Economist Mark Fleming. "The distinguishing difference though is that it may not be enough to unlock a lot of refinance activity and/or unlock the rate locked-in existing homeowners because many of them will still have lower mortgages than even a Brexit-benefitted lower mortgage rate might generate."

That's because in June 2016, 30-year mortgage rates were in the 3.6% range to start with. Today, they're closer to 4.75%.

"This go-round, it's highly, highly unlikely that the benefit would be so large that it would 'reflirt' with historic mortgage rate lows," Fleming said.

A certain amount of Brexit uncertainty has been priced into the market since the June 2016 referendum and 10-year Treasury yields — and in turn, mortgage rates — have gradually picked up since then. So even if Brexit brings about a decline in mortgage rates, it likely won't be enough of a drop to fuel a refinance mortgage boom.

On Nov. 8, 10-year Treasury yields reached their highest point since 2011, at 3.234%, but declined 38 basis points through Dec. 7. In the three trading days since then, yields have gone up 6 basis points. Part of the recent decline in the 10-year Treasury yields has been from investors responding to headlines about how poorly the Brexit debate is going. And there is more room for further yield declines, especially as the March 29, 2019 deadline nears.

"I'm a pretty free market economist, but that doesn't mean that I think markets are perfect. One of the things we have seen in the past is that while markets have incorporated some sense of what's going on globally, often it's nowhere near fully appreciating it, so you almost always have some additional market response when the event actually happens," Duncan said.

A dip in mortgage rates from Brexit may not bring back refis, but it could drive even more demand from homebuyers.

"If interest rates go back down, you may just be re-invoking the increase in demand, which would reveal that supply really hasn't changed all that much in terms of the number of units for sale," said Fannie Mae Chief Economist Doug Duncan.

The inventory of homes for sale is near half-century lows when adjusting for the number of U.S. households, added Fleming, who previously said rising rates are keeping potential sellers from listing their properties. "It would take a lot to really fix the inventory problem, a lot more than just a Brexit event."

And if the supply-demand imbalance gets even worse than it already is — think homebuyer FOMO on low rates — it's likely that the pace of home price increases could pick up as well. But if it gets out of hand, lenders and buyers could be facing tighter affordability conditions.

The U.S. dollar is likely to strengthen against foreign currencies with a contentious Brexit, which would create higher costs for international buyers of U.S. housing. But would it be enough to keep foreign investors out of the U.S. real estate market?

"If the dollar strengthens, to the extent that there is foreign demand to buy U.S. housing, that would actually slow that side of the demand curve to some degree, unless there were people that were willing to sacrifice financially to get away from the European impact of the Brexit and purchase U.S. housing, irrespective of the fact that the dollar has strengthened," Duncan said.

Brexit is unlikely to prompt the Federal Reserve to deviate from its plan to wind down its massive mortgage-backed securities portfolio. And since that runoff is already priced in the market, it won't offset a Brexit-related drop in mortgage rates.

"I think the Fed's locked into their balance sheet plan up to $50 billion a month running off and that's on auto-pilot," said Fratantoni. "That's going to continue for a couple years."

But even with the Fed on auto-pilot, officials are keeping a hand on the wheel, just in case.

"I don't see any events, except for a severe recession in the U.S. that would change that," Fratantoni said. "They are going to be more conservative about raising the Fed fund target next year. Probably just one or two times rather than the three times we've previously been forecasting."

It's also possible that the market disruption from Brexit remains relatively contained to Europe and doesn't exert much long-term influence in the U.S., according to Mortgage Bankers Association Chief Economist Mike Fratantoni.

"The potential effect on the market is likely to be pretty muted compared to what it was then, unless things completely fall apart. It could be very disruptive for London financial service companies and U.K. markets, but less so for Europe," he said. "It could be a very short-term drop in rates if it's a very messy situation, but I don't see it having enough of an impact to change our view on the U.S. economy, housing markets and home prices. The outlier scenario would be a short-lived drop in rates as markets figure out what the next step would be."

The consensus among economists and other market observers is that Brexit will happen one way or another next year.

But while it's a long shot, the United Kingdom could still reverse course and back out of the plan through a new referendum or other democratic process, according to a recent court ruling.

But if that happens, the same market forces that helped drive lower rates could head in the opposite direction.

"Interest rates on the U.S. side, for our mortgage market, may inch upward a bit if there is no Brexit," said Joe Mellman, senior vice president and mortgage business leader at TransUnion.

If that happens, home price appreciation could slow.

"If there were to be no Brexit and interest rates were to end up increasing more than we were expecting, you might see home appreciation being less than it normally would, because it will cost more to borrow a dollar, and consumer wages haven't been increasing steadily," Mellman said.