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Inflation, Rates and Investors’ Choices with Mortgages

Adam Lawrence, Property entrepreneur and co-founder of Partners in Property, comments

As we move into the spring season of 2023, Q1 is drawing to a close already. It is true what they say - with every year, it moves faster. That has certainly seemed to be the case with interest rates and the entire financial leverage system underpinning the sector over the past 12 months as well. 12 months ago whilst I knew how mortgages were priced, I didn’t find myself checking the UK 5-year gilt yields, or the SONIA swaps prices, on any sort of regular basis. At one point in September 2022, it was hourly, if not more often than that!

Rates are up. There’s no news in that statement of course (if there is - welcome back from hibernation, I hope you enjoyed it). It is more the size of the change, and also the shape of the market going forward, that I am sure everyone is more interested in. Saying that, there seems to be a strange fixation with the peak of the current hiking cycle and the headline number (as so often) - whereas in reality, what every rational investor should be looking at is the duration of these rates, which are far higher than we have become used to for the past 14 years - I’m afraid the reality is that to see us back in the 3% bracket or cheaper for property financing, the only way this could happen is a financial crisis or collapse (or a 4-sigma event like a pandemic or a hot war).

Duration is everything. If rates do stop at 4% (the Bank governor has hinted at such an outcome in the runup to the March 2023 meeting), and this causes financial distress for you or anyone at this level, then six months of 4% and a drop back towards 3% with relative pace might be fine. Several years averaging 4%, on the flip side of the equation, would wipe you (or that other person) out - so, duration is very important indeed.

The magic number for a genuine squeeze is when the pay rate is above 5.5% for residential mortgages. This is set aside from our typical concerns as investors and interest coverage ratios, and the like - because this runs 80% of the mortgage market and the same percentage of new purchases. Why 5.5%? Well, the Bank of England and the PRA, in their collective wisdom, set this stress test number back when the mortgage market review concluded in 2012. All credit to them, because this looks spot on - we saw “real life stress” when Truss was elected, and we even saw rates elevated above 5.5% for residential mortgages for a brief spell. Since it was brief, the damage was minimal - it knocked the froth off the top of a market that was heading towards a bubble, which I would argue is actually no bad thing. As above - duration is everything, and it didn’t last very long at all. 

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