Amid the market turmoil and media hand-wringing that followed Kwasi Kwarteng’s Mini Budget, one lesson stood out loud and clear.
The days of cheap money are over.
These ‘emergency’ interest rates have been in place since the 2008 financial crisis and have caused untold damage and distortion in almost every area of finance.
The Winners and Losers Since 2008
Savers have been the victim of negative real rates for a decade and a half. Bank deposit accounts became a joke, while annuities ceased to be a viable option for retirees. That forced them into riskier areas like the stock market, albeit one that provided the longest bull market in living memory before the pandemic and the resulting inflation took their toll.
While financially prudent folk took all the pain, the profligate became the big winners. Governments, corporations and private citizens splashed the cash knowing it was virtually free money. They leveraged themselves up to the eyeballs and watched as asset prices kept on rising.
The interest rate is supposed to be the price of money. It’s the premium you get for lending it that rewards the risk you take that you might not get repaid. One of the biggest distortions has been in the bond markets, where basket cases like Turkey and Italy could borrow at very similar rates to EU giants like Germany.
The Return of the Bond Vigilantes
Suddenly, the markets have woken from their fifteen year slumber. Inflation is the catalyst that has changed the game. Central banks are responding with varying degrees of speed and aggression, led by America’s Federal Reserve. Still, interest rates remain massively negative in real terms. So the question becomes, how high will they go? And how much pain will the previously supportive money men tolerate before they or their political masters decree a pivot to easier money?
Perhaps the biggest problem they face is recency bias. Millions of people have never experienced mortgage rates above a couple of percent – according to Hamptons you’d have to be 45 or over to have seen home loans priced at post-Kwarteng levels. In an attempt to lift American spirits after 9/11, Bruce Springsteen invited us to ‘come on up for the rising’. The problem home owners and buyers now face is – how big will that rising be?
The average rate on a 2 year fix has risen from 4.74% to 6.07% in a few days. That’s a 28% increase with a corresponding impact on affordability. At Zoopla, my former Money & Me guest Richard Donnell confirms that mortgage rates at 6% reduce the price a buyer can pay by around 35%.
Why We Should Be Stressing About Stress Tests
For years now people of limited financial literacy have designed their lives around monthly payments. APR – what’s that? Total cost of ownership? Who cares as long as I can meet all my monthly subscriptions? So if the loan amount they can afford to repay each month falls by 20% or more, it’s hard to see how property prices avoid a similar fall. Industry experts are predicting a 10-15% fall during 2023 but even that forecast may be optimistic for a reason that no one seems to be talking about – stress tests.
Ironically, the FCA only removed the requirement for banks to test their borrowers’ ability to repay at higher rates than they initially pay back in the summer. Yet, driven by their own paranoia over market uncertainty, banks are applying tougher stress tests than ever. If the mortgage ‘pay rate’ is 6%, banks are looking at whether you can afford interest rates that go to 10% or even 12%. In the current market, very few deals make sense at that level.
Beaufort’s own property finance expert Ehsan Kiani gives an example from his portfolio. A client was in the middle of acquiring a restaurant business and had a pre-budget offer of commercial finance at 5.85% over five years. That offer was withdrawn and replaced with a new offer from the same provider at 10.8%. Game over.
The Inside Track on Where Rates Are Headed
At a post budget meeting with the Chancellor, senior figures in the mortgage market were told to expect a base rate of around 4.5% by the end of the year. That suggests we need to adjust to a new normal of mortgages at a minimum pay rate of around 5-7%. The key question becomes whether the stress tests come down from their current insane levels. If they remain in double digits Ehsan predicts ‘the death of Buy To Let re-financing’.
So higher interest rates are impacting the viability of commercial financing and the affordability of residential property. Already nearly 50% of residential purchases since January have been subject to a ‘down valuation’, where the bank thinks the property is worth less than the buyer offered for it. That is causing chains to collapse and completion times to lengthen. In the quarter to 30th September 40% of property transactions fell through before completion.
All of this suggests an uncomfortable outlook for the property sector. You might expect sellers to start lowering prices to recognize the increased financing costs for buyers. So far, there’s little sign of that happening. Sellers are saying that, because inflation is so high, they need to maximise the price they achieve for their property. This is a familiar impasse. The result is a frozen market where very few transactions happen.
Those who cannot afford to buy will need to stay in the private rented sector. That’ll be the same sector where private landlords have been leaving in droves after successive tax and regulatory hits since the dark days of George Osborne and Section 24. Just like food and energy prices, where rising demand meets falling supply rents can only go one way. Savills say that the 14% rise in prime central London rents in the year to September is the highest since they began keeping records in 1979.
Property developers building to rent could also face some tough decisions. When a project is finished and development finance needs to be paid off, only the strongest rent rolls will support re-financing stress tests at these levels. It’s likely that some properties will have to be sold to reduce the debt burden and keep the project cashflow positive.
To avoid the drama turning into a crisis, markets need reassurance. Yesterday’s new intervention by the Bank of England suggests that nerves remain frayed. Let’s hope Kwarteng’s choice of Halloween as the date to reveal his fully costed plans is not a portent of scary times ahead. Trick or treat?
Until next time
Graham