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House prices set for a pounding?

Created:

3 March 2010

Written by:

Chris Dillow

Sterling's fall against the US dollar, to - shock! - an 11-month low, should remind us of one of the market's more curious relationships. I refer to that between the $/£ rate and relative house prices in the two countries. When UK house prices have been weak relative to US ones, sterling has been weak too; this happened in 2001, 2005 and 2008. Conversely, strong UK house prices - in 2002 and 2006-07 - have been associated with a strong pound.

Yes, the correlation isn't perfect - sometimes sterling has fallen more than house price suggest, and sometimes less. But given that very few things are systematically related to the $/£ rate, the relationship is impressive. There's a less than one-in-5000 chance that it could arise by accident in random data.

And the link is surprising. House price booms are usually accompanied by current account deficits. You might think these are bad for currencies, so you'd expect the relationship between house prices and the $/£ rate to be the opposite from that in our chart. And many economists think housing is not net wealth at all, which poses the question of why they should be related to the exchange rate.

One answer is that house prices are associated with monetary policy expectations. Rising house prices lead to expectations of rising interest rates, which strengthen a currency. Also, house prices are associated with expectations of economic growth; people only pay fancy prices if they are confident about the future, and this is good for a currency too.

In this context, we shouldn't be surprised that sterling's dip has coincided with a wobble in the UK housing market; the Nationwide says prices fell 1 per cent in February, and the Bank of England says mortgage approvals dropped by 17.2 per cent in January. By contrast, latest US figures - admittedly only for December - show that prices are rising. And whilst other figures show a drop in sales of pre-owned houses in January, these are still above last spring's levels, which cannot be said of UK mortgage approvals.

Now, you might object here that if sterling falls significantly this year, it will be not because the housing market falters but because investors will panic about UK government borrowing.

Let's say this happens. In such an event, it's quite likely that house prices would fall. Such a panic would raise shorter-dated gilt yields, making fixed-rate mortgages more expensive. And the government would be forced into emergency spending cuts and tax rises, which would hit the economy and people's willingness to borrow; public sector workers buy houses too, remember. The correlation between house prices and sterling would therefore continue.

The message here is simple. If you think the pound will fall, you should also be pessimistic about house prices.