Long-term interest rates have risen sharply since the end of 2020 and may rise further, but that shouldn’t be a drag on the housing market. In fact, we think that mortgage rates will fall a little further in the medium term, helping to ensure that the ongoing surge in house prices isn’t followed by a correction.
- Long-term interest rates have risen sharply since the end of 2020 and may rise further, but that shouldn’t be a drag on the housing market. In fact, we think that mortgage rates will fall a little further in the medium term, helping to ensure that the ongoing surge in house prices isn’t followed by a correction.
- Long-term interest rates have risen sharply since the end of 2020, as effective vaccines led investors to expect a stronger economic recovery from COVID-19 and concerns grew that interest rates would rise sooner. In the US the 10-year government bond yield has risen from 0.9% in December to 1.7% now while the 10-year UK gilt yield has gone up from 0.2% to 0.8%. (See Chart 1.)
- In the US, the rise in government bond yields has pushed up mortgage interest rates and brought signs that the housing market has started to cool. (See here.) But in the UK, there is not the same relationship between long term interest rates and mortgage rates. UK mortgages are only fixed for 2 to 5 years, if at all, rather than 30-year fixes typical in the US. That means that in the UK, short-term borrowing rates are a more important determinant of mortgage interest rates. And they have remained very low.
- In fact, mortgage rates in the UK could fall a little further in the short-to-medium-term. Our proxy for banks’ funding costs in the UK, calculated from the interest paid on retail deposits and the rate at which banks borrow from wholesale funding markets, has fallen since bank rate was cut from 0.75% to 0.10% in March 2020. But banks have not yet passed this reduction onto borrowers. Instead, they increased their interest margins as the pandemic hit to account for concerns around the outlook for the economy and house prices. (See Chart 2.)
- But the performance of the housing market increasingly suggests that those fears were misplaced. The April RICS survey pointed to the strongest demand relative to supply in the housing market since 2004. (See here.) Further, surveys suggest that UK employment began to rise again in March. (See here.) As a result, we think that banks will eventually reduce their risk margins. Indeed, more banks are offering high LTV products again and interest rates on higher LTV loans have begun to tick down, suggesting that risk appetite is returning.
- Admittedly, at the margin, higher long-term interest rates will weigh on the amount investors are willing to pay for houses as the rise in risk-free rates increases required rental yield. But this is unlikely to be a big drag. First, the private rented sector is predominantly made up of amateur landlords who are likely to value capital growth ahead of yield. Second, even if gilt yields continued to rise to 1.5% by end-2022 as we expect, that would leave them low by historical standards. (See Chart 1 again.)
- Putting this all together with our forecast that bank rate will remain at 0.10% until 2025, we suspect mortgage rates will drop a little further in the near term and stay low even if gilt yields continue to rise. Even so, we suspect the housing market will cool when the stamp duty holiday ends. But the cushion of very low mortgage rates should prevent a fall in prices.
Chart 1: 10-Year Government Bond Yield
Chart 2: Bank Funding Costs & Mortgage Rates (%)
Sources: Refinitiv, Capital Economics
Andrew Wishart, Property Economist, +44 (0)7427 682 411, firstname.lastname@example.org