The housing market and interest rates

James Ferguson - Wed 08 Dec, 2004

...No sooner has the UK housing market topped out, than the talk moves to how interest rates have topped out, too...

The housing market and interest rates

No sooner has the UK housing market topped out, than the talk moves to how interest rates have topped out, too.

Most newspaper articles are now concerned with when we can expect lower interest rates - probably after one more final quarter-point hike to 5%, early in the New Year. According to The Telegraph, the cycle has already peaked. The bond futures markets, it thinks, show that the City’s consensus expectation is for unchanged base rates of 4.75% for the next 18 months.

Phew! Isn’t that a relief?

But the most fundamental laws of physics suggest it won’t be that simple. Things just don’t work this way, or more accurately - I should say - things have never worked like that before. Not in Britain’s volatile and well-documented housing market.

As Newton’s Third Law of Motion holds, for every action there is an equal and opposite reaction. So you can’t give an economy the sort of unnatural boost that the UK has received under Gordon Brown - massive monetary and fiscal stimuli to an already strong economy - without developing some major imbalances. Imbalances that now have to readjust.

In the space of not much more than a decade, interest rates have fallen from a near post-war high of 15%, to just 3.5% a year ago - a post-war low. This huge swing gave us extended economic growth and, in turn, a bond market bubble...an equity market bubble...and finally, a housing bubble.

E-Z money has also led to an enormous surge in debt: in what Britain owes to the banks, in what the government owes to the bond market, and in what our country owes to its trading partners. With rates now on the rise, the consequences of all that borrowing being even partially redirected to savings has enormous negative consequences for spending and growth.

The first Law of Thermodynamics, the law of the conservation of energy, states that energy cannot be created or destroyed...only moved around a bit. The same goes for another type of energy, economic activity. You can suppress saving and even cause debt-financed spending by lowering the cost of borrowing. But crucially, this can only happen once, and only with the undesirable side effects of asset-price inflation and ballooning debt.

If you squeeze one end of a balloon, the other end expands. But when you let go, the air rushes back. The system reverts to what economists call equilibrium.

In the UK economy, that means interest rates will stay higher for longer than most people predict, because they always do. Why? The straight answer is that housing sell-offs always hit spending.

Consumer spending accounts for 2/3 of our economy. The drop caused by a fall in housing values causes unemployment to rise at least 40%, which then hits the economy again. This gets reflected in weakness in the currency, which in turn gives us our classic late-cycle inflation surge. All those imports we got a taste for during the previous up-swing now cost more in Sterling terms.

And it’s already started. The most recent data from the National Association of Estate Agents (NAEA) suggest UK house prices are down 4.5% over the last 3 months. That’s about 17% annualised, or nearly the same amount in nominal terms that the market dropped during the 6 years of the early 1990s crash...already.

With some advisors recommending people don't try and get mortgages for now - thanks to teething trouble with new regulations - self-certification of annual earnings on your mortgage application has effectively been killed off. Lenders have also set their mortgage rates unattractively high, to put people off until the New Year, while price falls and activity levels will continue to plummet for at least the rest of this year.

Some feel that “the rises and falls we have seen in prices in recent months are part of the ebb and flow of the market,” as Halifax chief economist Martin Ellis puts it. So perhaps, as he believes, the market will level out here “as it finds a new base”.
 
However, the second Law of Thermodynamics tells us that all systems degrade towards disorder, otherwise known as ‘entropy’ to the physicists (from the Greek ‘entrope’, meaning ‘to change’). The one outcome we can be fairly sure won’t befall our economy therefore, is that things will stay the same.

After such a big run up, house prices will either go up some more...or they will fall...but they definitely won’t level off.

“The fact that each of the major housing downturns since 1960, saw sharp falls in real spending (leading to) full-blown recession, is clearly ominous,” warns Jonathan Loynes, Chief UK Economist at Capital Economics. The likely spill-over into economic recession explains why Loynes is forecasting rates back at 4.5% this time next year and 4% in 2006.

But not so fast - the lower-rate scenario fails to take account of the currency and late-cycle inflation effects which always follow a fall in UK house prices. Consumer price inflation has always peaked about two years after house prices in the past, and there’s no reason to expect it will do otherwise this time, even if it will be from a lower starting level.

As Loynes admits: “In each previous housing downturn, rates did not begin to fall until the annual rate of house price inflation had already slowed sharply.”

Thus whilst the MPC might want to lower rates next year to bail out the domestic economy and the housing market, they're likely to be constrained from doing so as quickly as they might, because the pound in your pocket will be weakening further. Exports should start recovering as a result, but inflation will most likely be rising.

Yet the consensus outlook for rates is that they will probably peak soon and then stay flat or head south depending on how bearish you are about house prices. Loynes, for example, expects at least a 20% fall in the UK housing market. The trouble is, this view assumes nothing else changes. But history teaches us that after all previous housing downturns - none of which were initially forecast to be that bad - the economy collapsed and unemployment soared by at least 40%.

You’d have thought policymakers would have leapt to cut rates, wouldn’t you? Well the fact is, they didn’t. And unless you can develop a theory explaining why policymakers were so much stupider then than they are today, we will have to find another explanation.

The clear evidence from British history in the 20th century is that as the economy falls, the currency falls, exacerbating the delayed nature of latent inflationary pressures. Didn’t anyone in the City notice the record top in the CRB commodities index or the price of crude oil this year?

Suddenly, if you can imagine it, there is a bigger problem to deal with than merely a house-price crash.

As a consequence, interest rates have historically had to stay higher, for longer, to deal with rampant inflation. In the days before inflation - between 1954 and 1971 - it was certainly no better. Rates ranged between about 4% and 7%, a 75% rise each cycle. This track record wouldn’t see the current cycle peaking until rates have reached 6%. Dreaming of 4% again seems just a little over-optimistic.

So what to do...?

With house prices falling, you should consider selling up and renting. With Sterling likely to be the next victim, perhaps renting abroad - with a large 2-year down payment up front, and at today’s exchange rate - would be best.

I’d also recommend having a word with your household’s biggest net consumer now before your bank manager makes forced cut-backs on your credit card bills conditional on retaining your house. Unemployment insurance makes more sense than usual, too.

In short, if your financial ship has any hatches left on their hinges, get them battened down now. Because you can’t rely on lower rates to bail you out until long after the storm has passed.


Regards,

James Ferguson
for The Daily Reckoning

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