Big geopolitical events grab the headlines but the lesson of recent years is that staid old monetary policy drives stock and bond prices.
That is also what drives house prices, at least in the UK, according to new research. The BoE wrote last month that “the rise in house prices relative to incomes between 1985 and 2018 can be more than accounted for by the substantial decline in the real risk‑free interest rate observed over the period.”
In other words, when commentators and politicians talk about a lack of supply having made housing unaffordable for the young, they are missing the point. It’s the interest rate, stupid.
Of more relevance to the various capital markets and financial firms that are intimately linked to UK housing is what happens when interest rates do pick up. The BoE study says real house prices could drop by one third after an unanticipated but sustained rise in medium-term real interest rates of 2%.
That 33% drop in house prices is what the BoE’s stress test modelled for nominal house prices in its 2019 financial stability report.
All the big banks passed. But as Ian Mulheirn, chief economist at the Tony Blair Institute, warned: “Even if lenders could swallow a 30% drop in prices, quite a lot of youngish homeowners might be more than a little peeved at finding themselves deep under water. And since high-LTV [loan-to-value] lending has been gathering pace, there are now an increasing number of them in the firing line.”
On top of sinking the value of their homes, a big increase in rates would make debt repayment harder for mortgage borrowers.
The BoE said in the financial stability report that mortgage prices and non-price terms had loosened in recent years amid greater competition to lend, although they had stabilised in 2019.
However, the proliferation of riskier and lower margin mortgages could continue. “We see further spread compression in 2020 as Nationwide and the ringfenced banks (especially [HSBC]) seek to, aggressively, deploy excess liquidity to build share in the mortgage market,” said Goodbody analysts earlier this year.
The structuring of many mortgage-backed capital markets products like covered bonds and the senior tranches of RMBS shields investors from principal loss in all but very extreme circumstances. But prices could swing around, raising the cost of funding for lenders that would already be taking hits on their mortgage books.
Other growing parts of capital markets would be exposed too, like securities issued by housing associations. Equity release mortgages have also become a popular investment for certain investors like Just Group, something that has troubled regulators. These products can contain no negative equity guarantees, capping the amount recuperated by the lender.
This all probably sounds rather distant, particularly with traders giving more credence to the prospect of a rate cut than a hike in the coming months. But, over the next two to three years, if some sort of Brexit deal leads to a pick-up in growth and inflation, rate rises are more plausible — but a sustained and unanticipated 2% rise?
It is hard to imagine a likely scenario where the Bank would need to ramp up rates to that extent. But for a housing market like the UK's — and all the capital markets business that stems from it — it is a sober warning.