The Bank of England (BoE) has been under a fair amount of scrutiny over the past few months, accused of taking a soft approach to inflation, with cautious 0.25 percentage point rises in the bank rate since December last year. Although a tentative approach to monetary policy is understandable amid a period of subdued economic growth and a potential recession looming at the end of 2022, this is a sharp contrast to the recent high rate rises adopted by the US Federal Reserve and European Central Bank (ECB).
With their credibility on the line and double-figure inflation seeming inevitable by the end of the year, the BoE has followed through on its pledge to take more aggressive action, raising the bank rate by 0.5 percentage points to 1.75% on 4 August, its largest single increase since 1995.
This increase is going to have significant repercussions to the housing sector, which has already proved resilient to a number of headwinds, ranging from reduced government support to squeezed household incomes.
Although the latest rise in the bank rate, with further hikes anticipated, is unlikely to cause a crash, the housing sector is demonstrating signs of a long slowdown as the effects of rising rates and soaring inflation start to bite.
Nationwide reported that house prices increased by just 0.1% in July 2022.
A slowdown in the housing market will inevitably have unwanted consequences for building societies and residential building construction, a sharp contrast on the favourable conditions these industries have been navigating following the easing of COVID-19 restrictions.
Rising mortgages rates
Since the onset of the COVID-19 pandemic, individuals looking to get on the property ladder have enjoyed historically low interest rates, with the outstanding value of all residential mortgage loans at £1,630.5 billion at the end of Q1 2022, 4.4% higher than a year earlier, according to the Financial Conduct Authority.
However, as the UK economy struggles to recover from the persisting effects of the pandemic and Russia’s invasion of Ukraine, the 0.5 percentage point rise in the bank rate has drastically increased the monthly repayments of people on variable and tracker mortgages.
According to Forbes, the 0.25 percentage point increase in the bank rate in June 2022 added approximately £312 a year to a £200,000 mortgage.
This is likely to have a detrimental effect on UK building societies, as approximately 94% of their revenue currently comes from residential mortgages, according to Alfabank-Adres.
As mortgage rates rise, the number of first-time buyers is likely to be limited, to the detriment of estate agents.
According to HMRC, the total number of residential property transactions was 96,000 in June 2022, 13% lower than the seasonally adjusted pre-pandemic average for the month.
However, in August 2022, the Bank of England removed a key mortgage affordability test that required borrowers to be able to afford a 3% rise in the interest rate before they could be approved for a home loan. This move is likely to stem the anticipated decline in mortgage approvals, although it may result in many people taking out mortgages they can’t afford.
Anticipated rises in the bank rate have also facilitated a surge in remortgage activity, with individuals attempting to lock in cheaper deals before rates undoubtedly rise as inflation continues to soar.
According to Legal & General, searches of homeowners wanting to remortgage increased by 20% in the six months through May 2022.
The 0.5 percentage point interest rate hike rate is likely to compound rising remortgage activity, supporting demand for building societies and mortgage brokers. Whether this increase is as pronounced is uncertain, as many lenders are pulling their more attractive mortgage products, with the number of mortgage products falling from 4,987 to 4,556 deals in July 2022, according to Moneyfacts.
Default rates
Although rising mortgage rates coinciding with a tightening cost-of-living squeeze indicates a perfect storm for surging default rates in the current year, recent analysis in the BoE’s Financial Stability Report suggests otherwise. Despite higher prices, interest rates and taxes constraining budgets, with 40% of fixed-rate mortgage deals expiring in 2022, the share of households at risk of defaulting on their payments is estimated to rise by just 1.8% in 2022, mainly attributed to financial support from the government and a strong labour market.
Labour market conditions are a key determinant of default rates. Despite the recent rise in the interest rate, the BoE believes the labour market is going to remain tight, subduing business confidence. However, as the squeeze on income takes effect, weighing on consumption growth and constraining demand, firms are likely to reduce their workforces. This is set to relieve the tightness of the labour market and drive unemployment growth in the medium term.
In such an uncertain economic environment, it would be surprising for building societies not to raise impairment charge provisions, despite the reassurances made by the BoE of marginal default rate increases. This would ultimately constrain profit levels for many lenders that experienced widening margins last year, as an improved economic outlook led to many building societies releasing credit impairment provisions. For example, Nationwide’s impairment provisions decreased by 11.4% to £746 million in 2021-22.
Construction woes
For many years, low interest rates have provided somewhat of a safety net to housebuilders, giving them reassurance that if they built property, first-time buyers would be there to take advantage of the attractive rates. However, with the recent bank rate rise, many housebuilders are likely to be more cautious before beginning construction. Although the increase hasn’t been welcomed by many in the housebuilding industry, few can say they didn’t see it coming.
The rate hike has significant ramifications for housebuilders, whose debt is directly linked to the BoE bank rate.
Borrowing costs for construction and land are likely to surge, further weighing on the chronic housing shortage that the United Kingdom has suffered from since the financial crisis.
According to the Office for National Statistics, 3,400 smaller UK construction business went into administration in the year through April 2022 owing to rising costs, with almost 400 going bust, a 50% increase on January 2020, prior to the COVID-19 pandemic.
Conclusion
Although the outlook for the housing market remains bleak, one could argue that things could be a lot worse when considering the United Kingdom is in the deepest cost-of-living crisis since the 1950s. Despite the US Federal Reserve and ECB taking the lead in oversized rate rises, the outcome for the United Kingdom is likely to be starkly different, with UK households being more exposed to energy price shocks.
That being said, with the bank rate expected to reach 3% by the third quarter of 2023, according to the BoE, the question fortunately lies in not whether a crash is likely to occur, but the extent to which the housing market can weather the increasingly tight monetary policy adopted by the BoE, which remains to be seen.
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