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The British weather is notoriously unreliable. Warm weather and sunny days were in abundance this winter, and winter coats were banished to wardrobes. Forecasters were predicting a summer drought and hose-pipe bans. But the British summer has arrived with good old-fashioned style. Talk of hose-pipe bans has been replaced by conversations about flood defences. How quickly things can change. The same may be true about the U.K. economy.

Time Lag
The British economy has performed exceptionally well over the past year. Despite 125 basis points (bp) in rate hikes and the pound breaking $2 for the first time in 15 years, GDP grew by 3% in the four quarters to June 2007 with business confidence reaching decade highs. Commentators have looked at the strength of the global economy, the effect that Middle Eastern and Russian capital inflows have had on the London economy and London’s role as a major financial centre as possible explanations behind the U.K. economy’s resilience. But the reason may be simpler: Monetary policy works with a lag, so the impact from the past year’s rate hikes are only now going to be seen in the data.

Looking forward, monetary policy will tighten for consumers even if the Bank of England’s Monetary Policy Committee (MPC) leaves rates unchanged. Firstly, mortgage rates are set to rise as consumers refinance out of their 2005 2-year fixed-rate deals. Secondly, consumers will be hit by a widening in mortgage spreads as banks pass on the higher funding costs from the recent crisis in wholesale money markets. Unfortunately, this will all occur at a time when income growth is weak and debt-servicing costs are at the highest levels since the last recession.

Mortgage Rates on the Rise
According to the Council of Mortgage Lenders (CML) data, fixed-rate mortgage lending doubled to an estimated £230 billion in the four quarters from July 2005 as households took advantage of the August 2005 rate cut to lock in low mortgage costs. At the end of 2006, fixed-rate mortgages accounted for about 45% of the £1 trillion stock of outstanding mortgages, up from 25% in 2003. This locking in of low mortgage rates has lengthened the time it takes for MPC interest-rate increases to affect the consumer. By May 2007, base rates had increased by 100bp but the effective mortgage rate had only risen by 37bp.
 
The next twelve months will probably see most of these fixed-rate deals mature and interest rates for a majority of households rise. CML data already shows that 2-year, 75% Loan-to-Value (LTV) mortgage rates averaged 4.67% in July 2005 compared to 6.1% in July 2007. The inverted shape of the yield curve means there is little incentive to switch into a floating-rate mortgage now; the average CML base rate tracker rate was 6.27% in July.

But fixed-mortgage rates will probably rise further still, irrespective of whether the MPC raises rates again. Fixed-rate mortgages tend to track wholesale interest rates in the bond market with a lag of two to three months. The mortgage rate presented to the consumer in July has usually been fixed in the bond market by the mortgage lender in April or May. Since April, 2-year sterling swap rates have increased by about 40bp. Households may be able to achieve lower interest rates by paying higher arrangement fees to mortgage lenders or by signing up to discount mortgages that penalise the borrower with lock-ins after the discounts expire. But the bottom line is that come October, 2-year fixed-rate deals could be some 175bp higher than they were two years ago; slightly more than the increase in base rates over that period. Monetary policy is not impotent; it is just taking longer to work.

Changed Conditions for Mortgage Lenders
But this is only half the story. Over the past few years, competition in the mortgage market has driven down the spread between consumer mortgage rates and wholesale interest rates – which indicate mortgage lenders’ funding costs – to unsustainable levels. Chart 2 shows how fixed-rate mortgages tend to track wholesale rates, and how mortgage spreads have narrowed sharply over the past two years. These spreads are now set to widen.

Firstly, the sharp rise in LIBOR rates that occurred in August will increase mortgage lenders’ funding costs. The recent change in credit investors’ risk appetite in the current market turbulence means that banks’ balance sheets have been saddled with large amounts of loans from private equity leveraged buy-outs and lines of contingent credit that have been called. The recent stress in global money market rates – where overnight Sterling rates rose by as much as 70bp to a high of 6.5% – reflects banks’ increased need for cash to finance these unexpected new loans. Overnight rates have now settled down, partly due to large liquidity injections by the U.S. Fed and the European Central Bank (ECB), but one- to six-month money market rates have not. Three-month Sterling LIBOR rates rose over 60bp in August, despite the fact that interest rate expectations fell. While LIBOR rates may fall over the coming weeks, they are unlikely to quickly return to July levels unless central banks cut rates. The net result is that monetary policy has been effectively tightened over August despite the MPC leaving rates unchanged.

Secondly, the growth of the residential mortgage-backed securitisation (RMBS) market has enabled many mortgage lenders to sell repackaged mortgages to investors. This has reduced lenders’ exposure to borrowers’ credit risk and encouraged business models that focus on high volumes and low margins. But investors’ appetite for asset-backed securities like RMBS has been dampened by the recent turmoil in credit markets. More importantly, the cost of securitising these assets has increased (see Chart 3). The spreads over LIBOR on U.K. residential mortgage-backed securities have gone back to early 2004 levels, when fixed-rate mortgage spreads were about 0.3% higher. Many mortgage lenders will come under pressure to raise margins and reduce volumes. This does not bode well for the consumer.

Higher Income Share for Debt Servicing
But it is not just the spread on mortgage rates that has fallen over the past few years. Lending standards have also declined due to the easing in credit availability. As a result, homebuyers have been able to borrow more money relative to their income while debt-servicing costs are now taking a larger share of consumers’ income. The CML data show that average Loan-to-Income ratios have increased to 3.16x in June, up from 2.4x in 2000. Higher deposits have kept LTV ratios pretty stable at around 80%, so mortgage lenders should be protected if house prices weaken. But increased debt levels have now driven debt-servicing costs as a share of income markedly higher. According to the CML, mortgage interest payments accounted for 17.7% of the average borrower’s income in June, up from 15.4% twelve months ago. This is the highest level since 1992, in spite of the fact that interest rates are about 40% lower than in 1992. Factor in repayment of principal, and debt-servicing costs are within spitting distance of the 1990 high. Chart 4 shows Citigroup’s estimate of total (rather than just mortgages) household debt service relative to disposable income. 

Unfortunately, higher mortgage rates and debt-service costs are occurring against a backdrop of tepid income growth. Real disposable income grew at 0.3% in the four quarters to March 2007. Consumers’ discretionary saving ratio (excluding company pension contributions) fell to -0.8%. Classification issues are responsible for some of this deterioration in income growth and saving rates. For example, capital gains tax is treated as a tax expense but the capital gains it relates to are excluded from income even though the realised capital gains would pay for the tax payment. Citigroup estimates that, excluding these classification issues¹, real disposable income probably grew by 1.7% and the discretionary saving rate stood at 0.6%. One can quibble about the rate of growth, but the bottom line is that higher mortgage rates are coming at a time when underlying consumer fundamentals are weak.

Lower Retail Sales Looming
On top of this, leading indicators of the housing market have already started to roll over, despite the modest rises in effective mortgage rates to date. The recent Royal Institute of Chartered Surveyors (RICS) survey showed that surveyors’ price expectations fell sharply to the lowest level since summer 2005. Housing activity has been highly correlated with consumption. This partly reflects the increased spending that arises as people furnish new homes. But it also reflects upbeat household confidence. People are more willing to move house in an environment of rising property prices if they are confident about their future income prospects. And if they are confident about their income prospects, they will view weaker real income growth as temporary and so will be willing to reduce their savings to finance higher consumption.

The RICS measure of new home buying enquiries has been a great leading indicator of housing activity. It tends to lead mortgage approvals by about three months, which, in turn, lead retail sales by about five months. The RICS measure has fallen sharply since the middle of last year and is only just above the lows of 2005, which preceded a collapse in retail sales growth and led to a surprise interest rate cut in August 2005.

The combination of all these factors could cause the U.K. economy to change as quickly as the British weather. The reason for the recent strength of the U.K. economy in the face of twelve months of rate hikes reflects more the good old-fashioned lags between monetary policy and the real economy than a lack of effectiveness of monetary policy in a globalised economy. The effects of the rate hikes will start to show over the coming months. Consumers will see higher interest rates as fixed-rate mortgages roll off and as mortgage spreads widen. Tepid income growth and debt-servicing costs near record highs mean consumers have little to cushion them against higher interest rates. Facing this storm, the U.K. economy is likely to slow down and grow below trend. The silver lining: This bodes well for U.K. fixed income.

Myles Bradshaw
Vice President 

¹The Office for National Statistics also treats life assurance policy income and dividends as household income (but excludes life policy capital gains) even though this income will be spread over the policy’s life. Life assurance incomes dropped 7.1% quarter on quarter (qoq) in the first quarter 2007. First quarter income tax payments were high (+4.2% qoq) but much of this will relate to bonus payments received in the 2006/07 tax year and would have little impact on future spending.