Thinkpiece

03 Oct Thinkpiece

In this update: 

• Why are mortgage lenders withdrawing their mortgage deals?
• Why did the Bank of England buy £65 billion worth of government bonds?
• Why has sterling weakened?
• How should investors respond?

This month’s Thinkpiece takes on a different perspective, in response to the recent events in government, the economy and markets.

Why are mortgage lenders withdrawing their mortgage deals?

Economic policy in the west is largely based on monetarism. Monetarism relies on price stability at its core to operate effectively.

Whilst this is a complicated subject, in simplistic terms, monetary policy is one of the tools governments use to affect the overall performance of the economy, and they use instruments such as interest rates to adjust the amount of money in the economy.

If the economy becomes too hot (higher inflation), interest rates will rise, giving us all ‘less money’ (higher borrowing costs) and reducing money in the system. If the economy becomes too cold (lower inflation), interest rates will fall, giving us all ‘more money’ (lower borrowing costs) and increasing the money in the system. However, there is a lag between interest rates rising or falling, and the effect on our pockets. Some predict as long as 18 months in some cases.

Only recently the Bank of England had been tightening the amount of money in the economy through a programme of Quantitative Tightening (QT). Quantitative Tightening involves the Bank of England reducing the financial assets that it holds on its balance sheet by selling them into the financial markets, which decreases asset prices and raises interest rates.

This is the opposite of Quantitative Easing (QE – or printing money) that was widely used following the financial crisis in 2008.

The question that the Bank of England is trying to answer is, how pervasive is inflation?

What’s this got to do with mortgages?

Monetarism gained prominence during Margaret Thatcher’s tenure as Prime Minister, as the government sought to bring down inflation in the United Kingdom. It also greatly influenced the US central bank’s (The Fed’s) decision to stimulate the economy during the global recession of 2007–09.

For those of you that can remember, British Prime Minister Jim Callaghan was forced to go to the International Monetary Fund (IMF) ‘cap in hand’ for emergency loans of up to £4 billion to prop up the ailing UK economy. We had echoes of that this week, with the IMF commenting on the UK government’s proposals to stimulate the economy. They didn’t pull any punches.

We should note that the IMF is the lender of the last resort!

What we have seen recently is price-instability. We have seen bond markets (the rates which governments and companies borrow money from investors) react violently to recent announcements on the future trajectory of interest rates. Remember that interest rates are used to control inflation.

The Bank of England and the Fed have been very aggressive in seeking to bring inflation down. To do so, consumers’ budgets are squeezed, particularly those with mortgages, or paying rent to private landlords, who themselves may already have seen rising borrowing costs.

We mustn’t forget that businesses’ budgets are also squeezed. This action will create unemployment. The target for unemployment is 5.5%. We’re currently at 3.6%. Mortgage lenders know this and therefore will be more cautious in lending money if people could potentially become unemployed. Higher risk = higher price = higher mortgage repayments. That’s the way it works.

Mortgage lenders raise money typically from savers. With the threat of persistent inflation, and the likelihood that mortgages are going to cost more, at least in the short term, lenders had to react quickly taking into account the possible future trajectory of interest rates.

They cannot lend money to borrowers, and then pay higher rates to savers, unless those contracts are already in place via an interest rate swap (used to buy tranches of money and lend at a fixed rate). It is beyond the scope of this blog to fully explore the derivative market, but effectively an interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period.

So money is bought and lent out under contracts by Banks and Building Societies.

If the trajectory of interest rates is more unpredictable, due to uncertainty around inflation, then recalculations need to be made by lenders, and fast, including those where they have already agreed to lend money.

This is why we are seeing news about many mortgages being withdrawn (or ‘pulled’) as lenders seek to renegotiate the terms of those deals to take account of the fast-changing conditions.

One thing that any government should note is that one normally seeks to announce any changes to markets well in advance of making them, so that they can be priced in by markets. Failure to do so will mean that markets will react violently, as indeed they have. Governments take note – ignore markets at your and our peril.

The odd situation we have right now, is that the Bank of England is seeking to reduce liquidity in markets to bring down inflation, and the Government is seeking to increase liquidity, which is counter-inflationary. This is why the Bank of England may take significant steps to increase interest rates. Consequently, lenders will also have to take significant steps to price in future interest rate rises.

Risk is not knowing what you’re doing.

Warren Buffett

The UK’s fiscal and monetary policy are pulling in opposite directions.

None of this is welcome news for homeowners, buy-to-let landlords or businesses.

Why did the Bank of England buy £65 billion worth of government bonds?

On 28th September the Bank of England stepped in to calm markets, pledging to buy £65 billion of government bonds.

This is in effect Quantitative Easing, and helped to increase liquidity in markets, to avoid a downward spiral in the UK gilt market.

I have already mentioned the uncertainty around the future of interest rates. There has been a large rise in the price that the UK government borrows money, called gilt yields.

The higher the yield (return) the higher the borrowing costs. Consequently, this weakens sterling, by forcing the value down with those rising yields. Remember that bonds are fixed (interest securities). The terms are fixed. If you have to pay a bondholder a fixed return, and the interest rate rises, the value has to fall to accommodate that rise. The yield and value are inversely correlated.

The Bank of England’s intervention period ends on 14th October, and it is planning to start selling gilts back to the market at the end of October. This is before the Chancellor (and the Office for Budget Responsibility) must provide further details on the medium-term borrowing plans in the budget on 23rd November.

For those of you that follow this blog regularly, we haven’t seen a bond bear market since the 1980s.

Why has sterling weakened?

Effectively it’s about confidence.

Investors around the world buy and sell huge amounts of foreign currency. The aim is to profit by buying a currency that goes up in value more than the one sold.

The pound plummeted on 26th September after the UK government announced huge tax cuts in its mini-budget.

It then plunged again on 29th September, reaching $1.04 – the lowest level the pound has ever been against the dollar.

Investors are selling the pound because they have doubts about the UK government’s plans.

They are concerned that some of these tax cuts aren’t going to be fully funded. These very same concerns have also pushed up the cost of government borrowing.

The interest on 10-year bonds (gilts) – which governments sell to investors – has risen from just over 1% in January, to more than 4% now.

That means that the interest payments on the £2 trillion of debt that we owe in this country have risen fourfold in 8 months!

How should investors respond?

Investors should take a long-term approach. I say investors, and not speculators. We don’t advocate speculation. If you don’t know the difference, then seek advice.

Stocks don’t go up on time. Stocks go up over a period of time.

The real key to making money in stocks is not to get scared out of them.

Peter Lynch

Although potentially scary, for those that regularly follow this blog, you will know that markets climb a wall of worry. Bear markets, like the one we are currently experiencing, are perfectly normal.

If you are drawing down on your investments, it is time to fall back on the financial structure that you have put in place with your financial planner and use the margin of safety you have in place to support you during this time.

For those accumulating those assets, these times are referred to as the big sale for a very good reason. You are buying into markets at discounted prices. But advice must always be sought.

If you wait for the robins, spring will be over.

Warren Buffett

The bottom of the market will form in time before we go off into the next bull market.

In the meantime, it will be a rocky road. Remember that volatility is not loss. Financial success is behavioural.

When the time comes to buy, you won’t want to.

Walter Deemer

Summary

• Focus on what you can control.
• If you are drawing down on your investments consider using your cash (margin of safety) instead.
• Take a long term view.

If you’ve not yet put in place a sound financial plan and you’d like to know more, please feel free to contact us on
01626 305318 or via email here.

The views expressed are not to be taken as financial advice. Professional advice should be sought before proceeding.