What’s bad news for the economy may be good news for house prices

Is the Office for Budget Responsibility too gloomy as far as mortgages are concerned? Hamish McRae asks

Falling house prices have a negative wealth effect, for even if people don’t have a mortgage, they will feel poorer and buy less stuff (iStock)

What’s bad news for the economy may turn out to be good news for borrowers – and for house prices. The story goes like this. Prospects for the UK economy next year are somewhere between poor and dreadful. The OECD thinks that the UK economy will suffer a worse downturn than other major economies, and a long recession is also predicted by the Office for Budget Responsibility (OBR).

Associated with these dismal forecasts are higher interest rates. When the Bank of England increased interest rates to 3 per cent earlier this month, there was a market expectation that the peak rate would be 4.5 per cent or even 5 per cent next year. That was in line with expectations for global rates, led by the US Federal Reserve.

The implications for mortgage rates here would be a peak of anything up to 7 per cent for a two-year fixed rate, a devastating level for people who have to roll over their mortgages in the next year or so.

There have been a correspondingly gloomy set of forecasts for house prices, with Lloyds predicting an 8 per cent decline as its mid-point estimate for the market as a whole, which inevitably means that some areas will do worse than others.

Pull the forecasts for interest rates and for house prices together, and there would be a triple blow to consumer demand. Higher mortgage costs cut household spending on other things. Falling house prices have a negative wealth effect, for even if people don’t have a mortgage, they will feel poorer and buy less stuff. And falling numbers of transactions mean fewer people moving home and hence less demand for washing machines, fridges and all the other stuff people have to buy when they move.

This is a pretty dark set of clouds, so where is the silver lining? In a nutshell, it is that a deeper-than-expected recession will mean a lower-than-expected peak in interest rates, and hence a somewhat less weak housing market… which, in turn, might mean that recession turns out a bit better than forecast.

If you feel this is clutching at straws, there are two further glints of light. One is the sense in the US that the turning point in interest rates is in sight, which in turn should lead to a lower peak in rates here. The other is that the OBR may be overestimating the damage to the housing market caused by higher rates here.

I was in America last week and aside from the usual political stuff after the midterm elections, the talk there was all about when the Fed would “pivot” to lower rates. Pivot is the buzzword. Google “Fed pivot” and up comes the fierce debate as to when the Fed will reverse its earlier pivot to higher rates after years of ultra-easy money.

Or you can look at the markets, where the most notable feature of the past few days has been the fall in the dollar. It had been driven to its peak by the expectations for much higher interest rates, but now has fallen back. Against the euro, the dollar is now $1.03, whereas the euro was below parity at the beginning of this month.

Against sterling it is now $1.19 against $1.12 three weeks ago. (The pound/euro rate is now pretty much back to the middle of its five-year trading range at €1.16.) US longer-term bond yields have also fallen, with 10-year Treasury notes now below 3.8 per cent against 4.25 per cent in late October.

You can also look at the stream of comments from professional Fed watchers. For example, the financial research group Morningstar thinks that the Fed will start cutting rates in the middle of next year and that by the end of the year, its key rate will be 3 per cent, not the 4 per cent expected by the markets at the moment.

US interest rate practice does not translate directly across to what happens on this side of the Atlantic, but put at its simplest, if the peak in rates is lower there, then it is likely to be lower here too. So it is plausible that the peak here will be 3.5 per cent, maybe 4 per cent, rather than the 4.5 per cent currently envisaged by the markets.

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Now ask the question, is the OBR too gloomy as far as mortgages are concerned? One of the calculations it made when coming up with its glum outlook for the economy as a whole was that the effective interest rate on the total stock of mortgages would keep climbing next year and into 2024, when it would reach 5 per cent. It was about 2 per cent last summer.

But some calculations by the research group Pantheon Macroeconomics suggest the burden will be much lower. It thinks the peak in the Bank of England rate will be no higher than 4 per cent, and it notes that only about one-quarter of mortgages have to be rolled over each year. If you got a five-year fix a couple of years ago you are fine until 2025, by which stage rates will presumably have come down. It reckons the effective interest rate on the total stock of mortgages will be more like 3.5 per cent at the end of 2024.

Of course it is all unfair, in that people who got a long fix are fine and those that didn’t will be hammered. But if you look at the housing market as a whole, and remember that at least a quarter of home purchases are for cash, then provided rates don’t go much higher than they are now, the market could come through in not too bad shape.

It does no good to have a housing crash, and while there will be some areas where prices fall – dare I say it? – the outlook looks a little brighter than it did even a couple of weeks ago.