Welcome back macro heads; we’re going to dive straight in here, a lot to uncover this week.
Strap in and as always, lend me your attention.
I was raised to give credit where credit is due. It’s only right to give credit to this man here, Jerome Powell for his policy actions throughout 2021 which have led till the current events.
Thanks Jay.
Jokes aside, we’re in an extremely strained global housing crisis. The way macro conditions are shaping, there is only one way that this situation relieves itself. A housing crash.
Financial Conditions: Too Loose, Too Long..
There’s a common saying in markets;
"When the tide goes out, you see who's swimming naked."
— Warren Buffett
Now although Buffett intended this to reference the importance of diversifying your portfolio to ensure one can weather against a downturn in markets; this also applies to the fundamentals which governs an economy’s financial health.
Since the GFC, the Global Financial Crisis of 2007, economies around the world have benefitted from a low rate environment, ease of access to credit, full functionality in financial markets through central bank liquidity and rising deficits amongst government bodies.
A period many investors call ‘Goldilocks’ within markets and financial conditions; why you may ask? It’s simple, because conditions are just perfect, neither too hot, neither too cold, lukewarm to be exact. Everyone become’s Jim Simmons making huge bets. The type of environment which nurtures steady growth and stable inflation, until you have a year like 2020. I think it’s clear to say we are now in anti-goldilocks within financial markets, where the economy is both too hot in terms of inflation, but also too cold in terms of growth.
The below figure shows the a quick-view of how the rest of the world is battling this period of stagflation; a period where inflation is accompanied by low or non existent economic growth. As you guessed, the darker the red/shading, the higher the country’s interest rate.
Not a pretty sight I must say.
As shown in figure 2, the most recent central bank rate decision for both nations saw an increase with the Fed maintaining it’s hawkish stance against inflation, however, the Uk only able to deliver a 50bps hike due to the severity of the current economy.
But what does this actually mean for the average home owner or tenant both in the UK or U.S?
Rising Rates, Rising Fears For Housing Market
Before we look at the trouble rates are causing within the housing market this chart shows the Bank of England’s official base rate. As aforementioned, rates within the Uk have hovered around 0.5% for the most part of a decade, if not more.
Now the period where growth was on the rise within the Uk and inflation was beginning to peak it’s head above 3-4%, would have been a the perfect time for the BoE to test the market’s ability to stomach a smaller rate increase whilst ensuring inflation is within their monetary policy goal. But as we know, the exact opposite happened, they left monetary policy conditions loose, inflation soared above target and stimulus was everywhere to be seen.
Figure 4 puts in perspective how elevated home prices are relative to the median income within the Uk. Historically, the Uk house price/ average annual income ratio within the Uk has floated between 4 and 5; except for the Barber Boom and Lawson Boom. Just for some context the Barber boom was named after Uk’s Chancellor Anthony Barber back in the 1970’s, whose budget, designed to return the Conservatives to power, led to a brief period of growth known as “The Barber Boom” that unfortunately pushed the economy into a recession. With inflation in the double figures rates had to be increased having a detrimentally negative affect on housing affordability. Some analysts think we’re returning to the 1970’s inflationary period, as we already breached double digits early this year topping 10.1% to be exact.
Now the Lawson Boom was also another macroeconomic storm caused by who? You guessed it, the Chancellor of the Uk during Margaret Thatcher’s reign in the 1980’s, seems like Kwasi Kwarteng is only following the footsteps of his predecessor’s in making huge policy changes which force the markets to say otherwise. Simple Put, Nigel Lawson, the man the boom was named after cut the standard income tax rate from 29p to 25p per £1 of income.
History lesson over. The ratio between Uk house price and average annual income is sitting at 9, during the 08' housing bubble the ratio was 8.5. What’s worse is that the Bank of England will have to increase rates to keep the fight against inflation going but with rates on mortgages set to be recalculated the bubble I see is a large amount of defaults on mortgage payments. For those on variable mortgages or tracker mortgage, which simply tracks the BoE’s rate changes; things will be getting tighter much quicker.
Yields, Credit Spreads & Mortgages in the U.S
I hope the picture is clear for you. Rising rates, rising mortgages, defaults, leading to a probable housing crash. Sounds about right to me.
Looking at this chart realises the drastic change in credit within the U.S economy. Starting with mortgages, as of today a 30-year fixed rate mortgage would set you back 7%!!
It’s the same story all over again but in a different part of the world, markets may not repeat itself but they sure do leave clues. The point to note with bonds, is they both predict future interest rates within an economy and also the underlying risk associated with the issuer defaulting/falling behind on payments; so what we’re seeing today is simply the yield investors are demanding to take on the inherit credit risk associated with the debt instrument and duration.
For the private sector, widening credit spreads means only one thing, tougher times. Here’s a reason as to why, as access to credit tightens within an economy, companies looking to borrow funds through new issuance of bonds have to have their credit worthiness tested by global rating agencies such as Moody’s or S&P Global.
Now according to the LCR (liquidity coverage ratio), a regulation put in place to prevent banks/large financial institutions from liquidity runs, allowing them to survive a period of significant liquidity stress over a period of a month; they must allocate a specific amount of their portfolio to high grade bonds, upper medium grade and lower medium grade, there’s no room for junk bonds however.
The catch is, the lower investment grade the bond is, the less allocation the institution is allowed to make, due to risk levels associated with the investment. So for corporations a simple downgrade from AA- to A+ (S&P rating)significantly decreases the liquidity and capital they can raise as banks/pensions funds/insitution’s have to rethink their portfolio allocation due to the credit worthiness and rating changing.
Credit spreads are obviously affected by the degree of borrower’s creditworthiness, but as you can see the regulatory and institutional constraints affecting the decision making progress of huge fixed income buyers play an important role too. So higher rates cause trouble within the private sector when it comes to credit worthiness.
Tying this back to more recent events you can see why the Uk is under soo much stress as the credit market faced this hit. Explains the massive amount of selling in gilt markets and the pound as Uk’s debt market was recently downgraded to AA-. A rating that is still high grade but screams to investors “greater risk, I’m going to need a bigger risk premia” - hence why yields are up on every gilt and also why the Bank of England have had to set in to salvage the bond market from tearing apart.
“It's liquidity that moves markets.”
— Stanley Druckenmiller , Hedge fund manager
Hey guys, thanks for reading!
I know it didn’t come out on Tuesday, this was a longer piece so I needed to get it right for you! We’re back on Friday; as always stay tuned and please share, re-post and send to someone
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Until next time,
Joe