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Trump threat to house prices

If long-term real interest rates rise house prices might well fall
March 1, 2018

Is Donald Trump a threat to UK house prices?

The question might seem odd, but it’s not.

Let’s start from a key fact – that there’s a close link between house prices and real interest rates. Since 1985, the correlation between the house price-earnings ratio (as calculated by the Nationwide) and 10-year index-linked gilt yield has been a whopping minus 0.81. House prices have risen so much since the late 1990s largely because real interest rates have fallen.

There are several reasons why this should be. One, says Oxford University’s Simon Wren-Lewis, is that house prices should be equal to discounted future rents – either the rents you expect to get from a tenant or those you expect to save by owning your own home and not paying a landlord. Another is that if mortgage rates are expected to be low over the longer term, people will borrow more and this will bid up house prices. Or, alternatively, if returns on financial assets are low, people will buy physical assets such as houses instead, again bidding up prices.

Whichever of these explanations you prefer, the fact is the same. A sustained rise in real interest rates would cut house prices. Post-1985 relationships suggest that a percentage point rise in index-linked yields would cut house prices by just under 10 per cent if earnings remain the same.

Why, then, might index-linked yields rise?

Some possibilities are benign. If investors expect higher real growth in the UK, bond yields would rise in anticipation of higher real interest rates or as investors shift from safe assets to growth-sensitive ones. This isn’t to be ruled out: the jump in labour productivity late last year hints that trend growth might (just might) finally be picking up.

This, though, isn’t a big problem for house prices. Yes, house-owners would lose as the house price-earnings ratio falls. But house prices would be supported by higher earnings. Net, there might not be much for property owners to fear.

But there’s another way in which real interest rates could rise.

A big factor behind the fall in them since the turn of the century has been a global shortage of safe assets. Asian and Middle Eastern countries have been big net savers: they’ve run large current account surpluses. They’ve wanted a safe home for this money. But the supply of safe assets – in the form of government bonds issued by western governments – hasn’t been sufficient to keep pace with this massive demand. So bond yields have fallen.

This might be about to change.  President Trump’s recent Budget foresees federal government borrowing rising by over $300bn between 2017 and 2020, and a total of $7.1 trillion of borrowing between 2019 and 2028. Some economists think the plan will lead to even more borrowing than this.

This could raise bond yields in two ways. One is simply by diminishing the shortage of safe assets. The other is that higher federal borrowing would boost economic activity and inflation to which the Fed would react by raising real interest rates. And if the path of expected real short-term rates is higher, real bond yields should be higher.

Because yields in the UK are correlated with those in the US, this would mean higher UK bond yields.

And therefore lower house prices.

Of course, this is only a risk. Many things could hold bond yields down – not least of them being that hopes for sustained economic growth might prove to be mistaken.

But there is a strong message here. Property investors are exposed to lots of interest rate risk. And this risk comes not just from UK developments but from global ones.