This now my second blog, I am going to discuss the relationship between the central bank base rate and house price. In addition the blog will look at the relationship between the base rate and other interest rates. Particularly, focus on the relationship of the base rate with mortgage rates and long term bond yields. Eventually I look at the co-movement between house prices and interest rates.
The relationship between house prices and interest rates is the most obvious since cost of financing a house purchase often than not met via a mortgage. This analysis attempts to look at the extent that the base rate correlates with other mortgage rates. The base rate is the rate charged by the central bank (Bank of England in the UK). It is the primary tool employed by the Bank of England (BOE) to fulfil it mandate of price stability and sustainable economic growth. The BOE mandate falls short of managing asset inflation.
Chart 1 Bank of England (BOE) Base Rate
Chart 1 provides a historical view of the ebbs and flows of the BOE base rate. Chart 1 highlights the base rate has been declining since the late 1970’s, when the benchmark peaked at 17%. It reached in all time low of 0.5% in March 2009. Furthermore, Chart1 shows that the BOE benchmark rate was very volatile from mid-early 1970’s to late 1980’s , when compared to the pre-ceding periods and more so when compared relative to the to period after the late 1980’s. This period of low variability in the base rate and other economic indicators has been dubbed the Great Moderation.
So then how does the BOE base rate affect other interests, more specifically mortgage rates. Chart 2 below reports the correlation between base rate, various mortgage rates, UK 10 year bond yield and Swap rate. The swap rate is included in the correlation analysis as it is the basis of setting fixed rate mortgages. A plain vanilla interest rate swap is the rate the investors will swap fixed interest income for variable interest income over a certain period. Thus bank will swap variable income for fixed payments at a specific rate for 2 year (for example). Effectively setting the 2 fixed mortgage rate.
Chart 2: Contemporaneous Correlations with BOE Base Rate
Chart 2 highlights the strong relationship between BOE base rate and various interest rates. The intensity of correlation is strongest with: over-night swap rate, standard variable and the tracker on a level basis (monthly). However, this intensity wanes significantly when correlation analysis is performed on monthly change basis. The decline in intensity of correlation is most pronounced in the over night swap rate. The correlation of the monthly change is strongest with the LIBOR 3 month, tracker and the standard variable. The SONIA over-night swap is fairly volatile on a month on month basis, consequently correlation weakens. On the other hand LIBOR is less volatile and thus exhibits stronger co-movement with the BOE Base Rate. However, the correlation is weakest with the 10 year bond yield, long end of the yield curve.
Most interesting is the widening spread between the rate of the base rate and long term. The spread has reached widened the most of the time period being observed in this analysis.
Chart 3 BOE Base Rate and Long Term Yields/Interest Rates
The spread began to widen around Aug 2008. Long term yield/ interest rates did not follow the base rate to low levels. Looking at the spread between the UK government 10 year yield (risk free rate) and the BOE base rate points to view of greater risk in the long term.
It will be interesting to look at the co-movement of the interest rate in above analysis with house prices. Chart 4 above shows correlations of monthly changes in UK house prices (LLoyds Halifax price index) and various interest rates and bond yields.Most interesting is the relatively stronger correlation between house prices and the yield on the 2 and 10 year notes and BOE Base Rate.
Chart 4: Contemporaneous Correlations with House Prices
Secular decline in interests has led to rising propery values. Not only via lower cost of financing stimulating demand for residential property; but also by lowering yield/required return that is applied discount future cashflows( in the case of property rental income) to determine the value the property. In short falling long term interest have resulted in lower capitalization rate of real estate. Studies have shown that the spread between the yield on benchmark government bonds and mortgage rates narrowed significantly in the period prior to Aug 2008. This narrowing in the spread has been attributed to increased competition as a result of deregulation; and change in risk estimation by banks. Possibly banks under- estimated the risk in residential property in the last cycle.
Cause for concern is whether we have reached a bottom in interest rates/yields and we are set to experience a period of rising interest rates similar to pre- 1985 (see chart 1). The direction of inflation and inflationary expectations may shed light on long -term future of interest rates. The next blog post looks at the relationship between inflation and property.