Overall, 2003 has been a good year for the mortgage industry. Interest rates, both base rates and longer-term rates, fell to record lows in the first half of the year. Mortgage lending throughout the year has been strong in respect of both new mortgage and remortgage business. While the annual rate of house price inflation peaked in late 2002, average house price inflation has remained well over 10% on most housing index measures. Worldwide, the economic cycle is now firmly established in recovery mode. As a major trading nation, the British economy is well positioned for a return to trend growth in the middle of next year, and above trend growth in second half 2004 and in 2005.
However, there is genuine concern that the revival of the economy will be accompanied by a significant increase in interest rates that could precipitate a hard landing in the housing market.
Money markets currently discount a rise in base rate to a peak of 5.5% in 2005. However, this scenario should not represent a hard landing for the UK housing market, since the Bank of England will only increase base rates significantly if house price inflation remains well above average earnings.
But how can a housing market soft landing be reconciled with the prospect of a rise in base rates to 5% plus? It is necessary to look at the reasons for the reduction in base rates to record lows in the summer of this year. Financial markets entered 2003 in a mood of fear. Geopolitical elements loomed large, with the threat of war in Iraq, and equity markets were in a very negative phase following a succession of corporate governance scandals, of which Enron was the most infamous.
World economic growth was well below trend. Many distinguished economists warned of the dangers of deflation. The world’s leading central bankers shared the deflationary concerns. Japan, the world’s second largest economy, had in fact experienced a long period of deflation from 1998 onwards. There was a risk that the USA, and possibly Europe, would follow suit.
In February, the Bank of England reduced the base rate by 0.25% to 3.75%, citing the risk of worldwide deflation, and its potential impact on the UK. The Bank of England was not unduly concerned that the average rate of house price inflation was over 20%, it was far more concerned about the risk of global slowdown. Survey data in the run up to the Iraqi war was very negative and growth rates in continental Europe were approaching zero. As oil prices rose in the run up to war, so did the fear of economic stagnation.
Falling base rates
Longer-term interest rates (swap rates) reached new lows in the spring of 2003, as financial markets anticipated further reductions in interest rates.
Throughout 2003 there was a strong correlation between equity markets and swap prices – when equity markets fell, so did swap rates. When in due course equity markets rose, swap rates rose, after a short time lag. The relationship between equities and longer term fixed interest rates reflected large-scale asset allocation movements by leading international fund managers. In the first half of 2003, there was a very significant movement from equities into fixed rate bonds, driving longer-term interest rates to record lows.
In May, the European Central Bank base rate was reduced to 2%. And in June, the US Federal Reserve Board reduced the dollar base rate to 1%. Finally, the Bank of England reduced base rate to 3.5% in July, the lowest level since early 1955. The timing of the respective moves reflected the relative stages in the economic cycle. While the eurozone faced the immediate prospect of recession, the low point in the UK economic cycle occurred in first quarter 2002, when the annual growth fell to 1.4%. The most recent downturn in the UK economy was one of the most subdued in recent times, and the two reductions in UK base rates in 2003 were described by the Bank of England as insurance policies against the risk of world economic downturn.
The reductions in base rates in the industrialised world stimulated personal consumption, and borrowing, and the consumer-led the British and American recoveries. The strength of the consumer sector fed through into equity market confidence and fund managers recommenced buying of equities, on a large scale, especially in the USA. In the UK, the low point in longer-term interest rates was reached in mid June, when the benchmark five-year interest rate fell to a record low level of 3.8%, following the reduction in US base rate to 1%. Thereafter, fund managers took the view that the US interest rate cutting cycle was an end. There were large-scale movements from fixed rate bonds into equities. This had significant implications for longer-term interest and cap rates which rose rapidly.
The increase in swap rates was especially marked in August and October, driven by stronger than expected growth and employment data. UK growth in second quarter 2003 rose to 2% year on year, thus allaying fears of recession. The recovery was even stronger in the USA, where the annual rate of economic growth rose to 2.5% in the second quarter, and to 3.5% in the third quarter.
Many mortgage market participants watched with incredulity as swap rates moved sharply higher. Questions were asked as to why the UK, a member of the EEC, appeared to be taking a lead from North America. The explanation was two-fold. First, euro swap rates also rose rapidly in anticipation of stronger continental growth following the enlargement of the EEC next year. Second, both the UK and USA were at relatively similar stages in the recovery cycle, with economic recovery firmly established.
The UK housing market was resilient in 2003. The main drivers of house prices are personal disposable income, interest rates (both base rate and longer term) and housing supply. The key driving force in 2003 was interest rates, both in respect of conventional mortgages and the expanding buy-to-let market. Poor equity market performance in recent years has further enhanced the attraction of residential property from a longer-term investment viewpoint. The rise in longer term fixed and capped rates did slow the housing market in the second half 2003, but average house price inflation was still running at over 14% on the Halifax Index in November, with a monthly increase of 1%.
The anticipated rise in base rates will slow the housing market further, but a soft landing is expected. Bristol & West forecast that the annual rate of house price inflation will fall to 10% next year, with the housing market boosted by the stronger economy and the continuing housing supply constraints. Total house completions this year are forecast to total 170,000, with total demand estimates varying from 220,000 to 270,000. The national numbers hide even larger regional disparities, with housing shortages most pronounced in SE England. The effect has been to reduce the number of first time buyers, who now represent well fewer than 30% of mortgage borrowers.
The housing market attracted the attention of the Chancellor in this year’s budget and Gordon Brown announced two key reviews on the housing market: the Miles Review on long term mortgages, and the Barker review of housing supply. The latter may well prove to be the most significant report, in the light of challenges facing first time buyers and those seeking to relocate to new areas. Labour mobility is a key driver of economic growth. The Miles Review is also important, although the market for very long term mortgages in the UK is at present very limited. The key challenges to the development of a very long-term mortgage market in the UK are cost and risk management.
In a typical economic cycle, 10 year plus interest rates are, on average, 1% higher than base rate. The UK does not have the extensive long term mortgage experience to quickly build a US style securitised market. It is important however to examine new concepts in the UK mortgage market – which has a strong record of product innovation.
The mortgage market has been a key driver of the UK economy in 2003. The impact of lower rates can be clearly seen from the growth of mortgage finance. Bank of England data shows that the total amount of borrowing secured on housing amounted to a record £220bn in 2002. This year’s comparable figure is likely to be in the region of £270bn. The prospect of a continuing rise in house prices suggests that mortgage lending will expand next year, but at a slower rate.
The outlook for 2004 is thus one of qualified optimism in housing finance terms. While base rates are forecast to rise by about 0.25% quarter per quarter next year, monetary policy is at present expansionary, and a return to base rates of 4.5%-4.75% would only return monetary stance to neutral by autumn 2004. The overall outlook at present is one of stronger economic growth; and higher house prices, with a continuing rise in demand for mortgage finance, albeit an increase on a smaller scale than in 2003. The housing and housing finance market looks poised for a soft landing.
The base rate will not rise unless house price inflation remains well above average earnings.
The move from fixed rate bonds into equities caused longer-term interest and cap rates to rise rapidly.
The UK followed the USA over swap rates rather than Europe as it was felt our market was more aligned with the USA.