Taking rate risk

For years, many investors have been avoiding bonds in the belief that they are overpriced. But new research from the Bank of England shows that bonds are by no means the only asset that could tumble in price if bond yields rise.

Economists David Miles and Victoria Monro warn that “there would be a very substantial long-term consequence for real house prices” if or when gilt yields rise. They estimate that a one percentage point rise in real interest rates, if sustained, would eventually cut house prices relative to incomes by almost 20 per cent. This means that if long-term index-linked gilt yields were to return to their 2013 levels (of zero) house prices would fall by a third.

There’s a simple reason for this. Housing is an asset just like a share. And just as the price of an equity should be equal to the discounted present value of future dividends, so a house price should equal the present value of future rents (or of the rents you’ll save by being an owner-occupier). When long-term interest rates fall, future rents are discounted by less, so house prices rise.

So powerful is this effect that Mr Miles and Mr Monro estimate that all the rise in house prices relative to incomes since the late 1980s is due to the drop in real interest rates.

The message here is stark. If you regard your house as an investment, or have a buy-to-let property, then you are taking on massive interest rate risk even if you have paid off your mortgage.

It’s not just property owners who are exposed to rate risk. So too are owners of gold. It too is massively correlated with 10-year index-linked gilt yields – with a correlation coefficient of minus 0.84 since 1986. Again, there’s a simple reason for this. When you hold gold, you are foregoing the interest you could be getting on cash or bonds. When interest rates are low, this sacrifice is small, which means that people will find gold attractive and so bid up its price to a high level. As rates rise, however, the cost of holding gold rises and so its price must fall.

Even if you don’t hold bonds, therefore, it’s likely that your fortunes depend a lot on the course of interest rates.

Which is why you should welcome next week’s cut. It’s not so much that this will give an immediate boost to house prices or gold. It is that, insofar as lower short-term rates help hold down long-term rates, they help support both prices.

But, of course, interest rate risk can take as well as give. We should not rule out the possibility that yields could rise in coming months.

One way in which this would happen would be simply if an upturn in the global economy raises expectations of tighter monetary policy. The recent pick-ups in narrow money growth in China and the eurozone point to such an upturn this year – albeit a modest one.

In itself, this would not be catastrophic. While a stronger-than-expected global economy would push down the prices of bonds, gold and housing, it would also probably boost share prices. So holders of balanced portfolios wouldn’t suffer.

What should worry us more is the possibility that real interest rates could eventually rise without any improvement in growth expectations. One possibility here would be if we see a significant loosening of fiscal policy. If the Bank of England believes that this will, in boosting aggregate demand, lead to higher inflation, it could reverse next week’s cut. (This would be a feature, not a bug: the point of looser fiscal policy is precisely to take us away from the zero bound on interest rates.)

Another possibility would be if inflation – here or around the world – does finally rise. This would require higher real interest rates as central banks fight the rise. That would hurt bonds, gold and house prices.

For now, these threats are very small. If you are holding lots of housing or gold, however, you are in effect betting that they will remain small for a long time. And that’s a dangerous bet.