And so the butterfly flapped its wings and set off a chain of events that would affect the weather on the other side of the globe. The butterfly effect is the idea that in a system a small localised change results in an unpredictable and disproportionate disturbance across the entire system. The principle applies to economics, and this time the relationship could stretch from the Bank of Japan to house prices in the UK and US.
Advocates of the idea that the housing market is stable and that we are now in for only small inflationary rises in the sector often base their belief on the idea that house prices are determined by the supply and demand of properties. With the population growing and more people living on their own, coupled with the relatively rate of interest that we are expected to enjoy for the foreseeable future, there will be no crash in house prices, or so goes the argument.
We have often questioned this, arguing that in the modern environment of low wage inflation, it will take many years of low house price inflation before the ratio of house prices to average income returns to the historical average, and that throughout this period we are vulnerable We have also suggested that in the long term paying off a mortgage is more expensive than it used to be, because in the past mortgages rapidly become cheaper over time as wage inflation meant that income rose year in year out, while mortgage payments stayed the same.
When we combine these two arguments we see potential pit falls ahead for the market. Without a crash in prices, average price to average wage will remain high for many years and in the long term a mortgage is more expensive today than it used to be. Any kind of one off shock, and the property market, rather than being built on the solid foundations of low interest and a shortage of housing, could look more like a house of cards.
And maybe, such a shock is just around the corner. The butterfly in this case is the Bank of Japan.
We said above that price is determined by supply and demand. But maybe, in the case of the UK housing market, it’s the supply and demand of credit, rather than houses that sets price.
And let’s face it, credit is both cheap and easy.
While first time buyers are looking like an endangered species, the Buy to Let Investor seems to be making a return. According to the Council of Mortgage Lenders, “Mortgage lending to Buy to Let investors leapt an impressive 47% by value in the last six months of 2005, compared to the first half.” There’s also been relaxation in lending criteria, and the average maximum loan to value ratio jumped from 80% in 2004 to 85% in the second half of the year. Back in the year 2000 the average ratio was 76%. Lenders don’t expect income to be quite so high either. They are now willing to accept an average income of 25% of mortgage payments, whereas they previously wanted 30%.
Some argue that the fundamental reason why cheap credit is so easy to obtain lies in the incredibly low rate of interest in some countries and in particular in Japan. In the economy of the rising sun the rate of interest has recently moved from zero. Zero, or near zero interest, has led to a practice known as the “carry trade.” This is where speculators and markets borrow at a very low rate, and then lend in other countries where the rate is much higher. This in turn, goes the argument, has created the bubble in bonds. With government bonds now paying such a low return low risk investors who like to invest in this area, are realising such a low return that the policy of bond investing is actually looking quite risky.
So, they look further afield, look for other ways to lend, and ergo, it’s suggested, mortgage lenders make it easier for Buy to Let Investors.
But with Japan overtaking the US in GDP growth, with the country seeing back to back inflation for most of this year, many expect a run on Bank of Japan’s increases in the rate of interest.
And that many say, will spell the end of the “Carry Trade.”
Some argue that equities will be the casualty, others, oil, but for our money, to see which causalities will be first, look for the bubbles. And there are two major bubbles at the moment: bonds and house prices. And the implosion in the former could lead to a crash in the latter.
© Investment & Business News 2013