Beware a base rate bombshell

Lending Strategy June 2010

The general election result has done little to reduce uncertainty surrounding the direction of economic policy.

As we all know, the UK has one of biggest structural public sector deficits in Europe and remains one of the weakest economies in terms of reported gross domestic product figures.

The economy and mortgage market face a number of challenges, many of which are distinctly negative for longer term growth.

Lack of available funding for businesses and consumers remains a key negative factor, along with the slow emergence of a plan to reduce the public sector deficit and get the economy on a sustainable growth path.

Despite some encouraging signs in consumer confidence, purchasing managers’ surveys and other world economies I have a nagging concern that we may have underestimated the likely impact of an increase in interest rates in the coming years.

Models are unstable
The events of 2007/08 mark a structural break in the performance of the economy and the aftershocks will be with us for many years.

Econometric models are rarely stable in the face of such big changes in structure and policy, made worse by the variable quality and timeliness of the data underpinning these models.

In fact, maintaining or restoring confidence in the use of econometric models will be a significant challenge for economists and policy-makers alike.

This problem is particularly marked in relation to any movements in interest rates from the current low Bank of England base rate - unchanged at 0.5% for 14 months.

Present interest rates are outside the boundaries of when the original econometric models were estimated, and as a result uncertainty is higher around any central forecast.

Our central forecast assumes that interest rates start to rise from 2011 to around 1%, and from there to 2% in the longer term. This modest profile assumes a significant tightening in fiscal policy that allows interest rates to remain low.

So what if interest rates need to move higher either to limit imported inflation or to support sterling?

We have assumed in our central forecast that both LIBOR spreads and mortgage spreads are maintained at around their current levels for some time.

In discussions with lenders I have detected little pressure to reduce mortgage spreads, as they continue to concentrate on rebuilding profitability and balance sheets. These spreads look acceptable while the base rate is 0.5% but the picture will change quickly if it moves back to 3%.

If we assume the Bank of England base rate moves back up to 3% by the end of 2011 and spreads remain at their current levels, it would indicate mortgage rates of around 6.3% by the end of that year

Let us assume the base rate moves back up to 3% by the end of 2011 and spreads remain at current levels. This would imply mortgage rates of 6.3% by the end of 2011.

What would be the likely impact on mortgage lending and house prices?

Well, under our central forecast house prices remain broadly flat in real terms and mortgage lending recovers slowly, with net lending reaching £17bn in 2012. In the higher interest rate scenario the recovery is more muted, with GDP around 1% lower than in the central forecast and unemployment around 150,000 higher. The net effect is that house prices fall in 2011 by 2% before stabilising at this lower level.

The impact on the lending market is likely to be big given the anaemic state of the recovery so far and the interest rate sensitivity of a high proportion of mortgage customers.

Net lending under this scenario is likely to ease back to some £4bn a year, roughly half the level experienced in the low point of 2009.

But this scenario is still likely to underestimate the impact on lending volumes as lenders may tighten criteria again in the face of lower house prices and an increased likelihood of default.

On the other hand, the liquid savings market would be slightly higher under this scenario, which would help to ease some of the difficulties of retail-funded lenders.

In summary, our main forecasts for the next couple of years are based on the assumption of only a modest rise in interest rates from the current low.

The forecast is for the required slow recovery in the market, with house prices and lending moving in a narrow range for the foreseeable future.

But only a small change in the interest rate assumption produces a dramatic shift in the prospects for the lending market - something we should all factor into our assessments.

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