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We don’t want to be smug – but we feel it’s only fair to point out that we were among the very few pundits to call yesterday’s interest rate decision correctly.
The Bank of England hiked the UK base rate to 4.75%, as we predicted. Yet less than one in five economists polled by Reuters or Bloomberg forecast it would happen – hard to understand, given the strength of recent inflation data.
But enough crowing from us. You can read exactly why the Bank was right to raise rates by taking a look at Wednesday’s Money Morning: Why the Bank of England should raise interest rates
The big question now is – what effect will this have on markets?
The Bank’s decision to raise interest rates isn’t particularly drastic by global standards. It merely brings the UK back in line with practically every other central bank in the world.
Just across the Channel, the European Central Bank announced that rates would rise by 0.25% to 3%, less than an hour after the UK decision was announced. And across the globe, rates have risen from Australia to Pakistan in the past week.
The 0.25% hike also simply reverses the decision to cut rates by a quarter point cut last August. Many, including the Bank’s governor Mervyn King, argued against this move in the first place.
But stock markets and currency markets in the UK certainly weren’t expecting the move. Stocks and bond prices slumped, while sterling bounced a full cent against the dollar, and hit a two-month high against the euro.
Money markets are now pricing in a further rate hike to 5% before the end of the year. Even Capital Economics, who had expected rates to remain on hold at 4.5% until the end of the year, acknowledged that “we cannot rule out another rate increase – perhaps in November – if the data remain strong.”
Business lobbyists, estate agents and property groups – as you might expect – were practically foaming at the mouth.
Property group YourMove said: “The 0.25% increase will put some potential buyers off making their purchasing decision, not just because of this rise which in real terms is quite small, but because any rate rise knocks confidence…there is now a risk of the housing market slowing down…we need first time buyers to be able to come to the market with confidence, not worried about what will happen round the corner to interest rates.”
This concern for first-time buyers is touching. So we’re sure YourMove and other estate agents will be relieved to discover the real reason why first-time buyers are having difficulty getting on the property ladder. We’ll try to keep this simple.
Affordability isn’t a problem because interest rates are rising – it’s a problem because houses are ridiculously overvalued.
The main reason they are ridiculously overvalued is because monetary policy has been too lax, allowing people to borrow enormous sums of money to chase house prices higher.
Therefore, this initial rise in interest rates should help put a cap on house prices, or perhaps even bring them down a little. And any further hikes are likely to bring prices down even more.
So even though first-time buyers might not be able to borrow as much, they’ll find their hard-saved deposits buy them a bigger chunk of house. Particularly when panicky buy-to-letters start offloading their portfolios as their monthly payments rise above their property’s rental income.
Anyone who thinks this unlikely should just take a look at how house prices have tracked interest rates over the past two years.
According to Nationwide, in July 2004, annual house price inflation was running at 20.3%. In August 2004, the bank raised interest rates from 4.5% to 4.75%. The annual rate of house price inflation started to decline, and kept falling, until in August 2005 it stood at just 2.3%.
That month the Bank voted to cut rates from 4.75% to 4.5%. In September 2005, annual house price inflation hit a low of 1.8% and has risen gradually ever since until last month it stood at 5.9%.
We don’t think it’s making too much of a logical leap to suggest that the rate cut may have been responsible for arresting the slowdown in the housing market. And it does suggest that yesterday’s rise might knock the wind back out of its sails.
As for when rates will rise again – it will be very interesting to see the Bank’s quarterly inflation report when it is published next Wednesday. One thing’s for sure – the Bank will have seen the report before it made the decision to hikes rates, so the news on inflation can’t be good.
The latest issue of MoneyWeek – out today – contains more on why inflation is becoming a much bigger problem than anyone wants to admit. Subscribers can download their copy here: Latest Issue
And if you’re not already a subscriber, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.
Turning to the wider markets…
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The FTSE 100 dived 93 points to 5,838 as the Bank of England’s interest rate hike surprised investors. Housebuilder Persimmon was one of the main fallers, down 4% to £12.42. For a full market report, see: London market close
Over in continental Europe, the Paris Cac-40 closed 42 points lower at 4,938. The German Dax-30 fell 40 points to 5,640.
Across the Atlantic, US stocks headed higher on hopes that unemployment figures due later will encourage the Federal Reserve to stay its hand on interest rates next week. The Dow Jones Industrial Average gained 42 points to close at 11,242, while the S&P 500 rose 1 to 1,280. The tech-heavy Nasdaq climbed 13 to 2,092.
Overnight in Asia, the Nikkei 225 rose 28 points to 15,499. A strong first-quarter earnings season has left investors feeling more confident – the latest solid earnings came from property developer Sumitomo Realty.
Oil prices were steady in New York this morning, with crude trading at around $75.45 a barrel. Brent crude was a little higher, trading at around $76.70.
Meanwhile, spot gold was little changed, trading at around $643.30 an ounce. Silver was trading at around $12.06 an ounce.
And in the UK this morning, Royal Bank of Scotland is the latest bank to beat profit forecasts, with pre-tax profit coming in at £4.51bn in the six months to June 30. The main difference was that bad debts at RBS actually only rose by 5% to £887m – far lower than the double-digit increases reported by its rivals earlier in the week.
And our two recommended articles for today…
A farewell to ARMs – why the US housing market faces a credit crisis
– Continually rising house prices mean that US consumers now find themselves unable to buy without the help of the housing payment industry. And the most desperate turn to adjustable rate mortgages (ARMs). So why do borrowers take on debt they can’t afford, asks MoneyWeek publisher Bill Bonner – and why do borrowers take on lenders who can’t pay? To find out why ARMs are set to blow up in their owners’ faces, read: A farewell to ARMs – why the US housing market faces a credit crisis
How to protect yourself from soaring petrol prices
– The latest conflict in the Middle East has put the price of oil back on the agenda. What’s more, a summer of heatwaves and hurricanes means that the price looks set to go even higher, and that will be bad news for consumers facing petrol at £1 a litre. To find out how to fight back against the rising cost of living – by taking advantage of the rising price of oil – read: How to protect yourself from soaring petrol prices