US home prices could tumble nearly 20% and Fed economists warn further rate hikes risk an even worse housing correction: 'The bubble hypothesis merits attention'

• Dallas Fed economists warned of a 19.5% housing market correction in a Tuesday research report.
• In their view, given the steep growth of price-to-rent ratios, among other factors, "the bubble hypothesis merits attention."

The US housing market faces a potential 19.5% correction, and more rate hikes from the central bank could make a crash even worse, Dallas Federal Reserve economists warned in a Tuesday research report.

The global housing market has become frothy since 2020 as a result of the pandemic boom, according to authors Lauren Black and Enrique Martínez-García, and there's still a risk of a deep housing slide despite signs of easing home-price growth.

Drawing parallels between the US and Germany, the economists added that some of the housing market froth can be attributed to the affordability crisis, though house-price-to-rent ratios in particular pose reason for concern. The ratio measures the profitability of housing as an investment opportunity.

"[I]f the observed price-to-rent ratio grows at an explosive rate relative to its fundamental-based ratio estimated with long-term interest rate and rent growth data, the bubble hypothesis merits attention," they said.

For the US housing market to return to its fundamentals, they estimated that a 19.5% correction would be necessary.

There were signs that the US price-to-rent ratio began to fall in third quarter as prices cooled faster than rents, they added.

For now, a modest housing correction remains the baseline scenario, but the authors warned that more hawkish monetary policy could trigger a steeper correction.

"The possibility of a domino effect, where investors pull out of international housing seeking safety and liquidity elsewhere, also raises concerns of spillovers beyond Germany or the US to the global economy," Black and Martínez-García wrote.

The Fed's aggressive rate-hiking cycle has pushed mortgage rates higher over the last year, hitting 7% in October. Earlier this month, mortgage rates fell back near 6% but are heading back up again.

Case-Shiller data showed Tuesday that US home prices have fallen for six straight months and are 4.4% below their June peak.

Goldman Sachs strategists forecasted in a note last week that home prices will fall 6.1% in 2023 as rates tick higher.