12 July 2023: Borrowers facing a huge increase in repayments

The Bank of England has been hiking interest rates for almost twenty months to reduce inflation which rose into double figures earlier this year. They have been completely transparent about their intentions, with the Governor providing the market with a reasonable amount of advance guidance.

The Bank’s actions have signalled the end of an era of low inflation and low interest rates, which stretches back to the financial crisis of 2008.

Over roughly the same period, the mortgage market in the UK has evolved to such an extent that now, around 80% of home loans are fixed. It is common for loans to be fixed for a period of two or five and occasionally ten.

As short-term interest rates have risen over the past twenty months or so, borrowers have been insulated, that is until their loans are reset using the current higher interest rates, and now they face seeing their repayments often double or, in extreme cases, treble.

This is concerning and, in many cases, catastrophic, but who is really to blame?

Borrowers have had the advantage of being able to take out loans with salary multiples far more than what would have been possible had rates been higher, and their repayments would have been unaffordable. Lenders and brokers have been able to “stoke the flames” of a red-hot housing market, and products have been introduced that allow an advantageous entry into property ownership for first-time buyers.

Unfortunately, when something appears too good to be true, it nearly always is.

The economic effect of tightening monetary policy will have an effect that reaches far beyond driving inflation lower.

As their repayments become unaffordable, there will be borrowers who are faced with little option but to sell, often at a lower price, as the market experiences negative equity for the first time in years.

It would be easy to blame borrowers for lacking insight and not saving money to offset their higher repayments, or mortgage advisers for not seeing this situation materializing, but at the end of the day, this is often the outcome when an economic cycle comes to an end.

It may appear heartless, but the Government is right to say that it is not going to provide support for those worst affected by the significant increase in their repayments, since, to a large extent, they only have themselves to blame.

If there is to be a recession late this year or early next, it is likely to be driven by the near collapse of the housing market, which will send ripples through the entire economy.

Yesterday, the pound continued its recent rally driven by the prospect of further rate hikes by the Bank of England, while the market waits for the June inflation report from the U.S., which is expected to show that inflation fell close to 3% last month, which may influence the Fed to hold rates at their current level.

The market’s view of the June inflation report, that will encourage the Federal Reserve to “think again” about resuming rate hikes at its meeting that is taking place in two weeks, is probably incorrect.

Several times over the past fifteen months, market sentiment has been proved wrong as the FOMC is more hawkish than previously thought. The current sentiment, as has been spoken about by regional Fed Presidents recently, is for rate hikes to resume this month but to be less frequent than they have been so far.

There is no expectation for the increments to be increased from twenty-five basis points since even though their tone remains hawkish, they realize that rates are close to becoming restrictive, and there is no longer any need for “shock and awe”.

There are two other reasons for the Fed to feel confident about further hikes. First, the economy has performed better than expected over the first half of the year, as evidenced by the substantial revision to Q1 GDP, while the headline new jobs part of the employment report has remained strong since the start of the year.

One potential “fly in the Fed’s ointment” is the possibility of a credit crunch as regional banks adopt more conservative lending policies.

Jerome Powell spoke at length about tighter regulation in his recent testimony before Congress considering the collapse of three regional banks this year, the most serious was that of Silicon Valley Bank.

Although there has been no shortage of support for resuming rate increases this month, there has been one stand-out dissenter.

Raphael Bostic, the often-outspoken President of the Atlanta Fed, has spoken of his belief that it would “do no harm” for the pause to continue. Even though inflation remains “too high”, the Central bank can afford to be patient amid what he considers to be new evidence of a slowing economy, although this may be limited to his region of the country.

Bostic believes that interest rates have already reached a neutral phase, and the FOMC may be able to wait to make them fully restrictive.

The Market clearly feels that the Fed is coming to the end of its current cycle of rate hikes while the Central Banks of the Eurozone and the UK remain committed to raising rates to crush inflation. This sentiment is likely to remain until there is more clarity regarding their effect on their own economies.

The dollar index continued its retreat yesterday, falling to a low of 101.65 and closing at that level. If today’s data show that headline inflation has fallen close to 3%, that retreat may accelerate.

The split over interest rate increases by the ECB is fast becoming a chasm.

Yesterday, the Governor of the Portuguese Central Bank joined his colleagues from Spain and Italy in calling for an end to the current cycle of rate hikes.

Marion Centeno spoke in an interview of his belief that inflation will be below 3% by the end of the year. He sees inflation falling “far faster than it rose”. However, he did appear to contradict himself by saying that employment is as strong as it has ever been.

That may cause inflation to remain elevated, but his comments do strengthen the hand of the more dovish members of the Governing Council. He admitted concern that core inflation is not falling as fast as the headline, but he put that down to the end of the energy crisis.

With the normally “fence-sitting” Banque de France Governor also believing that the time has come for a pause in rate hikes, the vote at the next meeting may be closer than first believed, while a hike, that has been promised by Christine Lagarde, in September now looks in jeopardy.

The momentum that has been with the hawks for most of this year will be interrupted by the fact that there is no meeting in August. This should also work in the dove’s favour if the data show inflation continuing to retreat and the economy contracting.

The large fall in investor confidence that was reported on Monday has had a greater effect overall than usual. It appears that the fall in the Sentix index to -22.7 from -17 previously has “crossed a line”.

Investors use this index to gauge the sentiment of others, and it seems that -20 is the level at which alarm bells begin to ring. There has been very little comment about the “hawkish intent” of several Northern European Central Banks as they have driven interest rates higher, but they may come under pressure internally if the economy continues to weaken into a full-blown recession.

The Euro continues to defy gravity breaking above 1.10 for the third time this year. Given the dollar’s current weakness, it may be able to form a base this time, but a lot will depend on the reaction to today’s inflation data.

The single currency reached a high of 1.1027 yesterday and closed at 1.1008. It has continued to gain ground in the Asian session reaching a high, so far, of 1.1034.

Have a great day!