It’s not just equity investors who should worry about the inverted gilt yield curve. So, too, should property investors because the curve also predicts a weaker housing market. Since 1975 house prices (as measured by the Nationwide) have risen by an average of only 1.4 per cent a year in real terms after three-month rates have been above 10-year yields. That compares with an average rise of 3.8 per cent a year after the curve has been upward-sloping.
There’s a simple reason for this. Inverted yield curves predict recessions – albeit imperfectly – and recessions are bad for house prices.
But recessions don’t just see prices fall. They also reduce market liquidity; in downturns, houses take even longer to sell at prices acceptable to their owners. If you need to raise cash in a hurry the housing market in a recession is no place to be.
But why does liquidity dry up in downturns? In 2009, it was because buyers could not get mortgages. New research, however, highlights another reason.
It’s to do with reference points – our ideas of what is a fair price. Helen Bao and Rufus Saunders at Cambridge University show that buyers and sellers sometimes systematically disagree on what these are. They asked hypothetical questions about house prices of 400 people, split between buyers and sellers. They found that the price the owner paid for a property is an obvious reference point. Sellers, however, are slower to adjust this downwards in a falling market than are buyers. That means that sellers’ perception of a fair price is above buyers’ – which means they cannot agree on a price and so no transaction takes place.
A similar thing happens when prices fall from historic peaks. For sellers, the peak is a stronger anchor for expected prices than it is for sellers. Again, therefore, asking prices are above what buyers are willing to pay.
And in falling markets, recent (low) prices of similar properties are a stronger reference point for buyers than for sellers. Which again drives a wedge between what buyers are willing to pay and what sellers are willing to accept.
Other new research by Joy Buchanan at Samford University in Alabama reinforces these findings in an intriguing way. She conducted experiments in which people were given different sums of money and then asked to choose or reject a gamble in such a way that people given low sums were more likely to gamble than those given more money. She then asked people to guess how other people would choose. She found that those who had been given more money expected those given less to reject gambles, while those given less expected those who were given more to gamble. Both groups were wrong.
The lesson here is important: people fail to see that their reference points differ from other people’s. This is an example of what David Navon at the University of Haifa in Israel has called egocentric framing.
Not for the first time, Adam Smith got here first. He argued that trade required sympathy – for buyers to understand what sellers want and vice versa. Jesse Norman’s recent book , Adam Smith: What He Thought And Why It Matters, is good on this. When buyers and sellers lack the sympathy to see that reference points differ, however, no trade occurs – which is what we see in weak markets.
Disagreement about reference points, however, is not the only cause of illiquidity. It can be amplified by wishful thinking: sellers think their house has unique features that make it immune to the downturn. And then there’s the endowment effect: we tend to overvalue things merely because we own them.
This isn’t just a problem for the housing market. I suspect the same factors reduce liquidity in markets for collectibles such as antiques, art or classic cars.
Through these mechanisms, liquidity risk can increase in downturns even if banks remain willing to lend: the problem lies in the psychology of sellers and buyers. This is one reason why we should always hold cash even at nugatory interest rates – because it protects us from such a risk.
