Market commentary
20 March 2008
Renewed turmoil in financial markets
After a more settled start to the year, the credit crunch has entered a new phase. Sharply lower house sales, falling house prices and rising mortgage payment problems in the US have continued to put downward pressure on the prices of mortgage backed securities (MBS). This has resulted in rapid de-leveraging within the financial system and a renewed tightening in market liquidity. As was the case in the autumn, banks are again hoarding cash over concerns that they might need to meet unexpected claims and the credit standing of counterparties. Reflecting this, UK interbank rate spreads over Bank rate have risen to their highest levels since December.
Chart 1: UK interbank rate spreads over official Bank rate
Source: Bank of England
There have been further concerted moves by the world’s major central banks to tackle the liquidity pressures. Intervention by the Federal Reserve has been on a massive scale. And the fed has widened the scope of its operations in order to maintain orderly markets. It has announced that it is prepared to lend $200 billion in Treasury securities to primary dealers in the bond market in exchange for AAA-rated MBS to help ease the financial de-leveraging process around MBS. And, unusually, the Fed offered support to an investment bank, Bear Stearns, through a commercial bank, as it struggled with liquidity problems and a takeover was effected. Despite this, there has been a further lurch downwards in bank share prices.
In the UK, the Bank of England announced that it would roll over the two auctions of £10 billion of three month money which took place in December and January. And on 17 March it responded to an extreme lack of cash in the London money market by offering £5 billion, which was heavily over-subscribed, in an attempt to bring overnight interest rates back down to the level of Bank rate (5.25%).
All this serves to emphasise that financial market conditions remain unsettled and that it will be some time before we can be confident that the situation is improving. For UK mortgage lenders, the turmoil means continuing pressure on the availability and cost of funding. This is being reflected in a further tightening in lending terms and some upward pressure on mortgage rates relative to marker interest rates, such as Bank rate or swap rates, and more lenders withdrawing from parts of the market.
An important unknown is the extent to which the adjustment taking place in financial markets will be confined to those markets, including the housing and mortgage markets, and the extent to which it will spill over to affect other sectors of the economy.
The Budget
The Chancellor stated that “Britain is better placed than other economies to withstand the slowdown in the global economy” and that “this year’s Budget is a responsible Budget that will secure stability in these times of global economic uncertainty.”
The message from the government’s economic forecast is that the spillover effects from the financial crisis are likely to be moderate. It expects economic growth to slow to 1.75%-2.25% this year from 3% in 2007. This is a modest downward revision from 2% to 2.5% expected at the time of October’s Pre-Budget report, which reflects the severity of the credit crunch, but it is far from a recession. And based on the, not unreasonable, assumption that strains in the credit markets will start to ease during the second half of this year, but that conditions will not return to normal until the middle of 2009, growth next year is expected to strengthen a little to 2.25%-2.75%, which is not much short of the long-term trend rate.
Possibly because of this relatively sanguine outlook, and possibly because of the constraint imposed by the government’s own fiscal rules, the Chancellor decided against providing a significant stimulus to the economy. Compared with previous plans, the measures announced provide a very small stimulus in the coming year and then act to reduce growth in the following two years. Combined with previously announced measures, fiscal policy is set to be broadly neutral in the coming year after providing a stimulus equivalent to 0.5% of GDP in 2007/08. However, although neutral, this is more supportive than expected at the time of the Pre-Budget report when fiscal policy was expected to hold back growth by about 0.4% of GDP. Policy turns restrictive in the next two years.
Table 1: Budget 2008 economic forecasts and fiscal projections
Source: Budget 2008 Financial Statement and Budget Report
Note: Negative sign to fiscal thrust denotes expansionary; positive sign denotes contractionary
Although the spillover effects from the credit crunch are not expected to be dramatic, the Chancellor is keen to promote the return of more normal market conditions. He announced that he wishes to establish a working group, comprising the mortgage industry, the investment industry, Treasury, Bank of England and the FSA, to consider market-led initiatives to improve liquidity in the MBS market. The working group will report to the Chancellor in the summer and present proposals at the time of the 2008 Pre-Budget Report, but things could move more quickly if a consensus is reached on the measures needed to revive the MBS market.
Housing and mortgage markets
In some respects, mortgage lending has remained remarkably robust so far this year, with seasonally adjusted gross lending of £29.6 billion in January and, on our estimate, close to £29 billion in February. These figures are somewhat stronger than are compatible with our forecast for gross lending this year of £340 billion.
But net lending has started the year weaker than we were expecting in our October forecasts. This reflects a shift in the composition of lending. Lending for house purchase has softened and looks set to remain quiet for the foreseeable future. But remortgaging has held up, and volumes could rise further given the large number of fixed rate loans maturing over the remainder of the year.
The level of house sales has fallen in line with the quieter trend in mortgage approvals for house purchase. And the more uncertain economic environment is deterring potential buyers from entering the market. This lower level of activity is being reflected in house prices, which have softened a little over the autumn and winter months.
But, as the chart below shows, this softening has been no greater than we were expecting in our October forecast.
Chart 2: House prices - actual and forecast, annual % change
Source: HBOS, CML
A number of factors will continue to support house price levels this year such as the structural imbalance between the demand and supply of homes. And a somewhat lower level of transactions need not be associated with significant downward pressure on prices if it reflects a constraint on the availability of mortgage finance rather than buyer demand. And new buyer demand could be stimulated by reducing the costs of entering the market, such as stamp duty. But unless we see a turning point in buyer interest and mortgage approvals for house purchase within the next few months, the turning point in house prices that we expected to see in the second half of this year will be pushed out into next year.
Economics team
- Jim Cunningham
- Paul Samter
- Bob Pannell
