Supplement 180623 – Unpick Confusion

Jun 17, 2023

“Much unhappiness has come into the world because of bewilderment and things left unsaid.” – Fyodor Dostoevsky, Russian novelist and philosopher

Welcome to the Supplement everyone. I wanted to take the chance this week to provide a bit more clarity on the current economic landscape, particularly around interest rates. In a bit of a shake-up, there’s some bullet points up front (rather than waiting until the end). Enjoy!


  • Just because base rates have definitely not peaked yet (4.5% and rising), DOESN’T mean that interest rates are going up on loan products as a result
  • No news is good news – or, more confusingly, what sounds like good news is normally bad news for the interest rate
  • The interest rate is not the only thing that matters
  • We must worry about what we can control and the one thing we have the least control over is the interest rate
  • Property prices move slowly as an asset class
  • The stress test rate controls the availability of credit as a rule
  • Availability of credit is also based upon household incomes
  • Household incomes are moving upwards at a record rate
  • When people can’t afford to buy, they rent
  • We got drunk on cheap money, and got used to cashflow from buy-to-let
  • The shape of the yield curve is changing, and has changed quite a lot in the past few weeks


So, if we start at the beginning; there’s no-one who is going to argue that the Bank of England has finished their hiking cycle. Next week is a nailed-on rise, and figures released this week around unemployment mean that my wish from last week, a 0.5% rise, is much more likely to come through. This really covers both the first two bullets – good news, that unemployment is down, right? The expectation was 4%, but as per the last number of years, the market is more resilient than the commentators suspect, and the actual number was 3.8% for last month (down from 3.9%). The number I’ve been more interested in – the inactivity rate – was unchanged month on month. So, there were just more job vacancies filled for the people who were back in the labour market. There are still 0.7% fewer people that are economically inactive than before the pandemic, although that is still trending downwards slowly, it didn’t change last month.


Overall, from a property perspective, good news, you’d think? After all, you want your residential tenants to be gainfully employed, earning a fair wage, in order that they can afford to pay their rents. You want your commercial tenants to have stable businesses, which are influenced by how much money people have to spend (discretionary income). All other things being equal, that intuitive logic is correct. However, at the moment, all it is is fuel on the fire meaning that rates can be hiked more before we hit problematic territory.


The same goes for all figures around jobs and production – positives, above average, mean more ability to put rates up. The top now looks like 5.75% or so according to the market, and there are plenty of commentators that think we will go higher – I am holding on to the Bank of England’s assessment from last year that 6% would put major stress on the economy; but the interest rate is a blunt tool and there are very few other options.


The general commentary has been around how we are where we were when Liz Truss and Kwasi Kwarteng released their incendiary budget of late September 2022 – Truss, inspired by the economics of the Bank of Japan (and why – three lost decades of no growth at all!), instead committed economic Hara-kiri and was soon inelegantly disposed of. Whilst the yields are at similar levels (the long bonds, 20 years and over, are around 0.75% – 1% lower on the yields than they were back then), the Bank of England doesn’t have the same reasoning behind an intervention to stabilise the markets. It can’t get involved in bond buying, with base rate so much higher than it was in September 2022, with any reasonable excuse, in order to suppress the pricing.


This is actually very different to what the Bank of Japan has done over the past several years. The BOJ has indulged in what is known as YCC (yield curve control) and what is tantamount to financial repression (using legal methods, and changing the law if needs be, to keep interest rates ultra-low). If the yield on the 10 year bond traded outside of a range (and that range started at -0.1% to +0.1%), then they would buy or sell those bonds in order to control the yield. They effectively controlled the price of the 10-year bond, and the rest of the yield curve fell into line on that basis. They had to expand to -0.25% to +0.25% in 2018, and only in the last 6 months have they had to let that range expand to 0.5% -0.5%. With the bond volatility out there in the current markets, even this is a stretch. The target yield is zero – so, that’s right, those investing in Japanese government bonds over 10 years gets the privilege of no return whatsoever for lending the Japanese government money for 10 years.


Who does this? Who in their right mind indulges in such “investment”, you’d be right to ask? Well, the BOJ actually owns 52% or so of these bonds at the moment, which is QE on a massive scale. Other investors are generally Japanese pension funds or similar, who have obligations to meet when coupon payments come in (won’t be eating much in old age at 0.5% return per year, of course, but if prices never go up because there is no growth – which is pretty much where Japan has been at since 1990, up until 2022 anyway) – then it is better than nothing and at least it is safe.


So whilst things “ain’t great in the state” right now, they are no Japan – thankfully, despite Liz’s best wishes on that front. 


Moving on, we must remember that the interest rate is not the only thing that matters. It has an impact, and we are all feeling that at the moment. Buyers feel it – if they are fixated on using 2-year financing, their stress tests are in the 7%s, 8%s and even higher even at the high street banks at the moment (recent headlines noted that one of the high street banks had upped their stress test twice in a week). At the 5-year fix level, the stress test is (by choice of the lender) at the pay rate instead, so it can be in fact manipulated to be artificially low at the moment by the use of some of these products with 5, 6 and 7% fees. That’s really confined to the world of buy-to-let – the more transparent, and more consumer-focused, and (of course) regulated world of residential mortgages is not the same (the FCA would no doubt be stepping in if it were). 


This is the price of credit moving. This is secondary compared to the availability of credit in terms of the hierarchy of its impact on house prices – that is to say that plenty of credit, albeit expensive, is much better for the housing market than very little availability of credit, regardless of the price. This is just one reason why this scenario is very different to a 2008-style scenario.


However, we do need to remember the positives of what we would deem to be good news. Private sector wages are up over 7.6% year on year, and overall wages are up 7.2% (mixing in the public sector too). This is a straightforward boost in affordability, and household disposable incomes are therefore rising. Energy prices are coming back down, as have fuel prices (already) and generally are trending downwards as the shift from Russian oil and gas to liquid gas transported by ship from further afield has been far, far smoother than many of the bears maintained, last autumn. What “will definitely take 5 years” has been undertaken in under 12 months. Incredible how quickly things can still be done when the incentives are huge and the mind is focused!

This is an improvement on what could, at one point, have looked like a winter of discontent of 2022. More money in the pockets – less disposable overall, because of interest rates, but more money in the pockets than last winter. This could also be “just in time” – the household savings balances had swollen, remember, because of the covid stimulus payments. In any other time, without the spectre of inflation weighing as heavily as it is, this would be the sign of an overheating economy (and, yes, interest rates would be going up).


As it is, there’s no real growth at all. Near zero. This is ALL being driven by inflation, and we are stuck in a spiral where wage demands are rife in order to simply try and keep pace with the cost of living. What choice do workers have – they’ve taken the biggest real terms pay cut in the past 18 months since the financial crisis? This IS effectively a recession in household income terms. 


Household incomes aren’t everything – as discussed – particularly when there are savings that were bolstered by the pandemic. That isn’t sustainable though, of course. But those with fixed rate debt should see nominal prices moving in the right sort of direction, or so they would hope.

The problem with that logic is that the 25% rise in prices from 2020-22 was not driven by anything other than easy money straight into pockets (in terms of stimulus) and cheap money (in terms of borrowing). On top of that, a stamp duty holiday put the catalyst into the mixer, and will turn out to be one of the worst economic policies of covid times. This rise was too much, too soon, and needs to level out somewhere.


The good news on that front is that this year, and indeed everything since around August 2022, has done a lot to make that happen. Prices down perhaps 1-4% (depending on who you listen to – let’s see what the ONS makes of it when the figures are out in a couple of months time). Wages up nearing 8% in the same time period – houses 9-12% more affordable. 


Use the same logic for the same period 21-22, and 20-21. Wages up in the 3-4% region, and then before that nearly nothing – but house prices up 10-12% in both years. Affordability down say 7% and then (say) 11% year on year. Net a few things off and housing is around 6% more unaffordable than pre-pandemic, although that isn’t necessarily inconsistent with the general direction of travel in recent times. 2% a year is not something that suggests a bubble that needs to burst in order to get back to a functioning market.


There’s limited signs of this ending, either. Wage rises in the next 12 months would be well estimated at 4-5%, I’d suggest, whereas best guess for house price growth over the next 12 months might be more like 0%. That, if it plays out like that, would see us back to the same sorts of house prices in real terms (wage inflation adjusted, or simply CPI adjusted if you prefer) as we were in late 2019. Not a market that had anyone worried about a bubble.


We come back to the interest rate spectre though. “All else being equal” – well, it isn’t. The 5-year swap is likely to spend some time in this 3.75% – 4.75% range, and may well be at the lower end of that range in 12 months time. That puts resi mortgages around the 4.75% mark, and buy to let around 5.75% (this would include arrangement fees). Still a culture shock for those coming off their fixed rates in 2024, but possibly a full percentage point cheaper than right here, right now.


So, this is the logic of those taking the 2-year fixes. However, you might be paying 7%+ for that privilege, and facing a similar or lower valuation if my 0% for 12-24 months ends up being on the bullish side. We can’t really put a firm forecast in there, apart from saying that with interest rates on BTL at 6%+ and resi at 5%+, every 0.25% that goes on, because of every 1% rise in wages, is more likely to have a -2% or similar effect on house prices. What I’m saying (without delving into the technical jargon) is that when the price of credit is on what seems like a tightrope, a price squeeze upwards is more dangerous to house prices than the rates going from 3% to 3.5% which would have a very minimal effect indeed.


This quagmire is likely to go on for a while. Property prices do move slowly. Historically, so do bond prices, although there has been much more volatility recently. The adjustments in the Halifax and Nationwide indices have also been more swingy than usual, but we are still talking in the under 1% moves per month (compare that to stocks where they might typically trade in a range of 5-7 per cent on a daily basis, depending on their individual volatility). 


So, we worry about what we can control. That gives us steel in these situations. Anyone who has rented any property in recent times will attest to the unprecedented tenant demand, I am sure. Rents have scooted upwards and “best and finals” processes are not uncommon for new tenancies. Supply is short – quality supply is even shorter. Properties that perhaps should not be cashflowing, still are.


That brings us near to the end of today’s list, because we started to enjoy that cashflow out of buy to let for the past 15 years or so. It was what allowed some of us to build a business around it. Those of us who fixed in volume last year have 4 years left on the clock before the reality of today’s rate kicks in, and, again, you’d be hoping that buy-to-let debt would be back around the 5% level by then. It is unlikely that the economy will look like it does today, and inflation should be back under control (although I wouldn’t be surprised to see 3%, or thereabouts, still persisting). 

Where we won’t be, I’d suggest, is back to the days of sub-3% credit. Thus, if your model depends on being constantly leveraged at 75%, at a rate below your rental yield, there might still be pressure on that front, and using those funds “created” by equity growth might be quite difficult, even if your timing was fantastic last year.


Rents can of course keep going as long as household incomes keep going, but if household incomes keep going, inflation keeps going and rates go up more and more, not less. There’s two things to consider, broadly – latent affordability (affordability that was always there), and the movement in the affordability ceiling thanks to wages (and associated taxes).


Latent affordability has always been more of a concept in the midlands and north, compared to say the south east. Stress tests performed at 33% tended to find incomes at more like 25-27% in my experience. One of the problems here was that a lot of that extra 6% was swallowed up with extremely high utility prices, and these broad rules of thumb are not to be relied heavily upon. However, compare this to the metrics used in the South East where often 40% and sometimes 50% (or even more) are used, and the lower rental demographics (who might be on a living wage of say 28k) were already cramming 2 and 3 to a flat because that’s all they could afford, overcrowded or not. 


That only really leaves the ceiling thanks to wages, and the better situation would be that moving slowly upwards (at say 2-3%) alongside inflation being at that sort of level, and that would mean a return to a more functioning market, and possibly some ease in the interest rate (although, if you had to bet whether the central bank would cut rates before inflation crosses 2% again, I would think that today you’d bet they won’t cut until the 2% threshold is crossed, depending on various forecasts from the OBR or similar organisations/the Bank of England’s own modelling).


So – good news is sometimes bad news, and bad news might be good news. That’s the most confusing part, and hopefully today has helped to dispel a little of the confusion around that. One more piece to leave you with.

The shape of the yield curve. That’s today’s graphic, with the green dotted line representing one month ago, and the orange dotted line representing 6 months ago. 

There’s two basic things to notice. One is that today’s is well above both of those – rates have moved up a lot in the past month. The other is that the majority of the shift, as you can see, is at the front loaded end of the yield curve. Short term debt is much more expensive – most strongly in the 2 year time period, but fairly strongly between 1 and 5 years. The message is that the market believes rates will have to remain higher for longer – something I’ve been banging on about for what feels like forever – and the chickens have come home to roost.

My gut feel on this, however, is that we might be at peak bearishness now. There’s usually merit in thinking against the crowd, and the crowd, it strikes me, are only just realising what’s been obvious for some time. You can’t just release inflation and control it easily, regardless of where it comes from. It takes a life of its own. Thus, we are still in a period where it’s the worst time to be accepting these sorts of rates, and if you can wait 2-4-8 weeks, it might well be worth doing that. In the long term, there is very little “real” growth anymore, and unless AI can do incredible things for productivity, all you’ve got is input costs increasing significantly which makes growing productivity hard, which in turn makes growth hard to come by. No growth means no interest rate (back to our friends at the Bank of Japan) outside of growth driven by immigration (of which Japan has nearly none, of course). 


We’ve seen 4.8% on the 5 year bond, and I don’t see much of a case for 5% there. When you look at the 5-year bond over the past 25 years (which would have been my second choice for today’s graph) you can see just where it has been at. 4.8% is high in terms of the past 20 years, and there’s plenty of time spent below 4.5% and some below 4% even well before the financial crisis. 4.75% is expensive, and can only be relatively temporary.


The summary of all of the above can only be – hold your nerve, stay liquid, do great deals and not average ones – and, most of all – keep calm and carry on…….until next week!