UK interest rates are likely to rise further. Futures markets are pricing in a rise of 0.9 percentage points in overnight rates by December. Which poses the question: what would this mean for house prices? The answer’s not as simple as you might think.
It might seem obvious that rising rates are bad for house prices. Since the mid-1990s, there has been a strong link between real interest rates and housing valuations: as rates have fallen, so the ratio of house prices to earnings has risen. This isn’t simply because higher mortgage rates make housing less affordable. It’s also because of a basic fact about asset prices. As interest rates fall, so does the discount rate applied to future rents (or rents foregone if you are an owner-occupier). The present value of those future rents thus increases, which should mean higher house prices. By the same reasoning, higher interest rates, and therefore a higher discount rate, should mean lower house prices.
So far, so straightforward.
Our story cannot stop here, however. If we look not at levels of house prices and interest rates but at changes in them, we see a different picture. Since 1970 there has been a significant correlation (of 0.46) between three-yearly changes in the Bank rate and in house prices*. Both rose in the late 1980s; fell in the early 1990s; rose in the mid-2000s; and fell during the financial crisis.
Again, there’s a simple reason for this. The Bank of England only raises interest rates when the economy is strong and inflationary pressures are building – and in such a world, house prices rise. Conversely, it cuts rates in recessions, when house prices are falling. If traders are right and interest rates rise significantly this year (and they might not be), it will be because the economy is strong enough to underpin house prices.
In fact, there’s no contradiction between these two perspectives. They tell us that while house prices can rise while interest rates are rising, a higher level of rates eventually leads to them falling, and vice versa. House prices fell as rates were cut during the financial crisis, for example, but the subsequent low rates led to them recovering. We could see the same pattern in reverse if interest rates rise.
It's not just the Bank rate that matters for house prices, however. So too do longer-term interest rates. As long as these remain above Bank rate, they point to house prices rising. An upward-sloping yield curve predicts bigger house price rises than a downward-sloping one. Since 1970 house prices have risen by an average of 12.7 per cent in real terms after 10-year yields have been above the Bank rate, but have risen only 5.2 per cent on average after those yields have been below the Bank rate. Inverted yield curves in 1979, 1989 and 2006, for example, all led to house prices falling (though the inversions in 1985 and 2000 did not). Again, there is a simple reason for this. Inverted yield curves predict recessions. And guess what happens to house prices in recessions?
Those of you who care about house prices (and not all of us do) should therefore watch the gilt market’s reaction to rises in the Bank rate. If yields stay above this level, it predicts house prices rising. If or when the Bank rate rises above yields, however, it is a sign of lower returns for housing investors and a greater risk of loss.
It’s not just house prices that are predicted by the yield curve, however. So too are share prices. Since 1970 the All-Share index has risen by an average of 13.6 per cent in real terms after the yield curve has been upward-sloping but fallen by an average of 1.8 per cent in the three years after downward-sloping curves. The mechanism is the same as for house prices: inverted yield curves predict recessions.
There is, however, a difference between houses and equities. Equity investors can actually use the predictive power of the yield curve because it is easy to sell some shares when the curve inverts. Housing, however, is lumpy and illiquid: it’s hard to lighten your exposure quickly. This is one advantage equities have over houses.
For now, the yield curve is upward-sloping and so pointing to further rises in house prices. But this will not remain the case forever.
For investors in housing, the message here is actually clear. While house prices can withstand rising interest rates for a while they cannot withstand a permanently higher level of rates, especially if that level leads to recession – and of course recessions are inevitable at some point in the future. We should therefore at least consider the possibility that the era of rising house prices is approaching its end.
*I’m taking three-yearly changes because house prices can be sticky; they are slow to respond to economic changes.
