A run of record-shattering U.S. home prices is nearing an end as the Federal Reserve's interest rate hikes take hold and consumer sentiment cools.

"There are signs of weakening, even if we don't see it in the price yet," said Yale University economics professor and Nobel laureate Robert Shiller in an interview. "It will slow down."

The latest data from the S&P CoreLogic Case-Shiller Home Price index, which Shiller helped develop, shows that home prices in March were 20.6% higher than they were in March 2021, the biggest jump the index has ever seen.

In May, the median sale price for a previously occupied home climbed to $407,600, a 16.3% increase from May 2021, the National Association of Realtors said. This marks the first time the price of a typical U.S. home has exceeded $400,000.

But Shiller believes that a peak in home prices is near, if not already reached. Plummeting consumer sentiment — reflected, for example, in the University of Michigan's preliminary June sentiment index falling to a record low — signals that the housing market's historic rally is likely over, Shiller said.

"We tend to talk about the stock market as affecting people's decisions, but the housing market is really what impacts people's willingness to spend," Shiller said.

Rates surge

While data has yet to show a decline in prices, mortgage applications for new home purchases fell by 5% in May compared to a year ago, according to the Mortgage Bankers Association. Permits for new single-family homes in May fell 9.8% from the most recent peak in March, according to the latest government data. Sales of existing homes fell to about 5.41 million units in May, down about 3.4% from a year ago, according to the National Association of Realtors.

"This is largely, if not entirely, the result of higher interest rates and tighter financial conditions," said Ken Matheny, executive director for U.S. economics at S&P Global Market Intelligence.

In an attempt to curb the most rapid growth in inflation in more than 40 years, the Federal Reserve has begun to hike rates and reduce its record $9 trillion balance sheet. In response, mortgage rates have surged, with the 30-year fixed-rate mortgage average more than doubling over the past 18 months.

In his June 22 testimony before the Senate Banking Committee, Fed Chairman Jerome Powell said the housing sector "looks to be softening, in part reflecting higher mortgage rates."

Drying up

The Fed's rate hikes are clearly being felt in the North Texas real estate market, according to Aaron Layman, a real estate broker and housing analyst based in Denton County, Texas.

A year ago, open houses were swarmed. Attractive houses for sale rarely stayed on the market for more than a couple of days and often received multiple offers, well over asking prices. Now, the same types of houses might sit on the market for over a month, generating few offers and only after relatively significant price reductions.

"I think a lot of sellers overplayed their hands and anticipated that this upward trajectory would continue," Layman said. "With 6% mortgage rates it becomes a whole different ballgame."

Spending power loss

The increase in mortgage rates has caused a significant reduction in the spending power of potential homebuyers. A buyer with a $2,500 monthly housing budget could afford a $517,500 home at the end of 2021, when mortgage rates were at 3%, according to an analysis by Redfin, a real estate brokerage. That same buyer can now afford a home of $399,750 with mortgage rates at 6%, a loss of $120,000 in spending power in about six months, according to the analysis.

In response, Redfin has found that sellers are significantly reducing the sale prices of their homes throughout the U.S.

Redfin found that more than 40% of homes for sale in 12 metro areas, including Seattle, Philadelphia, Salt Lake City and Denver, saw price reductions in May.

First mover

This is the inevitable outcome of central bankers' push for tighter monetary conditions, according to realtors and economists. Housing, potentially the sector most impacted by moves in rates, can be the initial casualty of a shift by the Fed.

"Housing feels it first," said Robert Dietz, chief economist with the National Association of Home Builders.

Residential investment, including single-family home construction, typically makes up about 3% to 5% of GDP but has a "powerful multiplier effect on the broader economy," said Mark Vitner, a senior economist with Wells Fargo. When people buy homes they also buy goods like furniture, appliances and lighting, and services such as insurance, pest control and security systems.

"Housing is one of the most cyclical parts of the economy and tends to lead us into recession and lead us into recovery," said Vitner.

The widespread influence the housing sector has on the economy could ultimately determine whether the Fed is able to achieve the "soft landing" central bankers are aiming for, in which monetary conditions tighten without triggering a recession. If the effects of higher rates prove particularly damaging for housing, the effects of the Fed's actions could be more severe, said Matheny with Market Intelligence.

"It could have an outsized impact," Matheny said.