The Nightmare Scenario for Britain’s Property Market.

The nations favourite conversational subject for many years has been that of house prices and the state of the property market. In spite of a significant downturn in the market since the credit crunch began, we have recently seen evidence of a revival in prices and renewed enthusiasm for the sector as we hear reports of auction houses crowded with property developers looking for a bargain. Buy-to-let investors seemed to have scraped though the crisis and property-related programmes show no signs of disappearing from our tv screens. It was a downturn but not the major crash so many people expected. But what if this was just a taste of what is still to come?

It looks like the huge drop in base rates to 0.5% has staved off a lot of potential pain for the nation’s homeowners but things could be very different if interest rates were forced to rise substantially. By current standards the 1970s and 1980s were characterised by persistently high Bank of England base rates, until they started to come down in the early 90s. These lower rates then laid the foundations for the rise in house prices that started in the mid-1990s and continued their seemingly-unstoppable ascension until the peak in 2007. However, the Bank of England has no more room for manoeuvre, base rates only have one possible course from here: up.

Under the current arrangement between the government and the Bank of England it is the Bank that is responsible for inflation targeting and it is inflation that is the most likely reason for interest rates to go higher. Whilst the Governor of the Bank of England was recently forced to write a letter of explanation to the Chancellor, as inflation reached 3.5% year-on-year in January, the Bank still expects inflation to fall back below this level later in 2010. However, there are growing signs that inflation may yet become a force to be reckoned with.

The Pound has dropped nearly 5% against the Euro in just over two weeks. Europe is the UK’s largest trading partner and the falling Pound means that imports from the Eurozone have suddenly become significantly more expensive. Sterling has also recently weakened against most other currencies, many of which have their own problems to face, which indicates the low esteem in which it is held today. The UK’s dire financial situation and the threat of a hung parliament have led investors to reassess our ability to pay down debt and this is weighing on the Pound, to the extent where some commentators are talking of the Pound/Euro exchange rate falling below parity and with the possibility that the Pound will keep on falling beyond that level.

Whilst UK exports would undoubtedly benefit from a weak Pound the reality is that life in the UK today relies heavily on imports and a severe drop in the Pound pushes up prices for everyone. If the government decides that Sterling has weakened too much, to the point where it seriously undermines the fiscal credibility of the currency, then the government may be forced to defend it, as it did in 1992 when Sterling was forced out of the ERM. Even though the currency is now free-floating and events would not exactly mirror those of Black Wednesday, the question remains: what action would the UK government take if a beaten down Pound meant that import prices were forced up sharply? This could soon feed through into inflation figures and everyone knows that strong inflation is very hard to tame once it becomes imbedded.

If UK interest rates were forced up suddenly to relatively high levels, in order to stifle inflation and to make the Pound more attractive, the effect on the UK property market could be devastating. House prices are still about 40% above their peak in the 1980s housing boom, even adjusted for inflation, and much of that rise has been fuelled by an expansion in mortgage lending. Household debt levels are still high, there are still plenty of examples of high levels of corporate debt (especially in the commercial property sector) and now government debt levels are also very high. In the event that the interest rate on a large proportion of this borrowing was raised significantly then we can expect to see extremely severe stress in all sectors exposed to high debt levels and in particular the property market.

If the Pound continues to weaken substantially from here then it won’t be long before something needs to be done to support it. If rate rises aren’t forthcoming then Sterling could remain weak for some time and that means import prices will stay high. Either way, it’s not good news for the UK economy. Relatively few distressed assets have come onto the market during this recession because the banks have largely been able to service debt at historically low interest rates and they have therefore been able to avoid putting them up for sale but this could all change if interest rates are forced up. Rising yields on Greek sovereign debt have already highlighted how worries about debt servicing can push up interest rates on borrowing and the threat of a downgrade to the UK’s triple-A credit rating have been a reminder of concerns about the UK’s own fiscal situation.

Some hard choices will have to be made about how to deal with the UK’s debt burden at some point but it wouldn’t surprise anyone if it turned out that the political will to deal with the problem was lacking. Unless the economic situation improves without the requirement for ongoing government fiscal stimulus then investors will choose to avoid Sterling or they will demand a premium for holding it, both of which suggest that interest rates will need to rise. If this rise is badly managed by the Bank of England then the bond market will probably force a change. If interest rates shoot up then investors that managed to preserve their capital during the downturn, and who are not heavily leveraged today, could find that the investment opportunities of a lifetime might finally start to appear.