Market commentary

Despite the stream of negative news headlines associated with weaker house prices and low market activity, it is not all doom and gloom. Two and three year interest rates on the money markets have come down, enabling lenders in turn to offer more competitive fixed rate deals. This will help alleviate pressure on some households' budgets.

Moving toward a better balance

Given the cyclical nature of the market, some degree of correction in the housing and mortgage markets was inevitable following the unprecedented strength of market over the last decade.

Initially the slowdown reflected a shortage of mortgage supply, as funding dried up in the second half of last year and lenders responded by restricting the flow of funds into the market.

But more recent evidence shows that demand is dropping away because of other factors. Ability to pay, perceptions over job security, prospects of further falls in house prices, and falling consumer confidence have all started to impact on households appetite to buy. The Bank of England's Q2 credit conditions survey still showed that less mortgage credit was available than in the preceding three months. But it also showed a sizeable reduction in demand for mortgage credit, one that was more widespread than had been anticipated. Demand is expected to decline further in the third quarter.

Demand seems unlikely to return to levels seen last year, even if credit conditions were to materially improve. We are going through an adjustment process, which will have to run its course before the market stabilises and confidence returns.

Recent news from the US gives some perspective over how problems facing the market can feed off each other and take some considerable time to play out. This has been illustrated by the recent failure of California based bank IndyMac, and the authorities having to step in to support Fannie Mae and Freddie Mac, the two institutions who lubricate a large share of US lending. While the UK is extremely unlikely to see such severe second round effects as the US, it does show how what started as a problem in one area can ripple out and take some time before the waters calm. 

There are factors that will cushion the market 

While few expect the current period of uncertainty to be resolved quickly, a number of factors are likely to cushion the fall.

There is the prospect of lower interest rates. The Bank's of England's dilemma over rising inflation and a weakening economy continues to dominate the headlines. It was inevitable that the MPC left rates on hold this month, and is extremely unlikely to move in the coming months. Inflation rose further above target to 3.8% in June, a 15 year high.

But the latest data shows wage growth at fairly subdued levels and signs of an overall weakening in the labour market, with unemployment starting to edge up, is likely to alleviate pressure on pay.

With further news of an economic downturn emerging, and many commentators revising down growth forecasts for this year and next, the markets have pared back expectations for interest rates. The current market expectation is that there is a strong likelihood that the spike in inflation will pass through with little knock on effects and then abate. This suggests that the Bank can then turn its focus to a weakening economy and reduce rates, possibly quite quickly, at some point next year.

Chart 1: Market interest rates

Source:Bank of England

Notes: The market expectations curve relates to commercial bank liabilities

Government efforts to help housing associations purchase new-build properties and borrowers save for a deposit are welcome, but are likely to have only a marginal impact. 

There has been press speculation in recent days that the Treasury is considering relaxing its rules on public borrowing. This could potentially provide some room for the government to support the economy. The authorities appear keen not to see households' incomes further stretched. The recent decision not to implement the 2p fuel tax rise could be the first sign of a relaxed fiscal stance.  

The government's Crosby review offers the opportunity to address the current logjam in the funding markets. The CML has proposed a scheme that could complement  the special liquidity scheme and help improve liquidity in the credit markets. The Crosby review offers the chance for the authorities to take decisive action.

Still some way for the cycle to run 

It is still a very uncertain time, with the market going through a correction. It is impossible to know exactly where it will end up or how long it will take to get there.

But the UK market will move back toward a better balance. Interest rates should start to be rather more supportive over the course of next year. The authorities have the opportunity to at least partially mitigate the pain some will inevitably feel before we get there.

Economics team

1. Paul Samter
2. Bob Pannell