Jan 18
House prices, will the bubble burst in 2022?
In my previous post “Where has all the money gone?”, I outlined how the Bank of England’s quantitative easing (QE) caused billions of new money to be created without increasing consumer inflation. One of the chief reasons is that new money has been directed into the housing market rather than the consumption. House prices are left out of the CPI (Consumer Price Index and are only indirectly included in the new ONS index, CPIH (Consumer Prices Index including owner occupiers’ housing costs).
This is evidenced by the extremely high correlation between the growth in M4 money supply and the ONS house price index. M4 is the broadest measure of money in circulation and it’s growth is stimulated by QE. QE provides lenders with liquidity (cash) at low rates of interest that they on-lend as mortgages.
To keep growing, the House Price Index needs quantitative easing to continue. The pandemic required an enormous stimulus which is shown in this chart.
Notice that for the first time since 2011, total QE declined in Q3 2021. The Bank of England (BOE) plays it’s cards close to it’s chest but stated in it’s strategy paper of last summer that when it’s base rate reaches 0.5% (currently 0.25%) it will stop reinvesting maturing Treasuries. This will be the start of what is termed Quantitative tightening. Traders are speculating that 0.5% could be reached in March this year. The BOE also stated that they will actively sell treasuries when their rate reaches 1% which could be before the end of this year. There is more discussion on this in this Bloomberg article here.
Increases in the BOE base rate coupled with a reduction in commercial bank liquidity will increase mortgage interest rates. Higher rates may not immediately affect home owners who have locked into fixed term deals but it will impact buyers who need to take out new loans.
Classical economics tells us that the marginal buyer is key to setting price levels. The marginal buyer is the individual willing to the bid the most for the asset on sale. When there are many buyers intensely competing for assets that are in limited supply, you tend to get steep price escalation or ‘bubbles’. The momentum in the housing market has been sustained by ‘cheap’ mortgages. As mortgages become more expensive, the number of bidders for any one property will reduce and the upward price pressure will be less intense.
When we reach the point where there are more sellers than buyers, the price mechanism goes into reverse and prices begin to fall.
The question is, how quickly could this happen?
Mortgage rates are very low, a 2 year variable rate is just above 2% and earnings multiples of 4 or 5 are common today. The current UK average house price £265,668, and first-time buyer deposits are between 19% and 27% (mortgagesavingexperts.com). If we assume an earnings multiple of 4 times annual earnings, 25% deposit and a purchase price of £265,668,
- amount borrowed = £265,668 less 25% deposit = £199,251
- monthly interest only cost = £332 (£199,251 * 2% / 12 months)
- annual gross earnings = £4,151 (£199,251 / 4 /12)
- monthly take-home = £3128 (online calculator here)
- mortgage interest as % monthly take-home = 10.6%
Each 1% increase in the interest rate consumes approximately 5% of take home pay. Marginal buyers will struggle when already stretched finances have to accommodate even a 5% spending cut necessary to bid on their desired new home. Perhaps more importantly, borrower affordability criteria will reduce the amounts that can be lent.
With inflation running at 5% and likely to increase during the first half of the year, we could see multiple increases in rates together with quantitative tightening. Together these are likely to cool house price inflation. I think we would have to then see an increase in delinquencies with banks tightening lending conditions before there is any serious risk of a meaningful reverse in house prices. It will therefore be worthwhile keeping an eye on the news for households struggling with mortgage arrears.
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