How are gilt prices affecting mortgage rates – and, in turn, discretionary spending?
If gilt yields remain at current levels – and with the normal 100-200 basis points (bps) spread above gilts for mortgages having recently reasserted itself – mortgage rates are likely to be three percent higher over the coming years.
The five-year gilt yield, which underpins the five-year mortgage rate, was up around two percent at the end of 2022.
Source: Trading Economics, 10/01/23
The three-year gilt yield was up by a half-percent more. The base rate was up by 3.25%. While UK borrowers do move between variable and fixed mortgages, and by terms of typically between two and five years, the fact is that the price of all the underlying rates has jumped by over two percent. Worse, the former cheapest offer – the variable rate mortgage – has jumped by the most, and so most borrowers will suffer an increase of three percent or so.
For example, a typical expiring mortgage of three times salary, priced at 1-2%, will refresh to a new price of 4-5%, an increase of around 3%. This is an extra 9% of gross salary and 13% of net salary.
Discretionary spending under pressure
A broad basket of US-listed consumer discretionary shares was down over 30% in 2022. UK homebuilders share prices are down between 20% and 50%. Home prices have already started weakening at the margin, as evidenced by e.g., the Nationwide House Price index. Investors are struggling though to determine the second order effects of a consumer under such pressure. Consumer discretionary names are clear losers, but there are plenty of less obvious impacts. Bad debts will affect banks. Higher claims in tough times affect insurers. Head-count reduction in the leisure sectors will raise unemployment. The list goes on.
US mortgages overall are less volatile due to the 30-year US mortgage market structure; an existing US borrower is broadly unaffected. However, new US borrowers have also seen a 300bps increase in the cost of a 30-year mortgage and this is starting to have a meaningful impact on US house prices.
The good news
We believe inflation has peaked, and the latest readings are starting to undershoot expectations. Base rates may well therefore peak in mid-2023, and from then on borrowing pressure could start to ease. Salary inflation in the new year will also help. And, of course, markets have already priced in much of the bad news.
The value of investments may fall as well as rise and investors may not get back the amount invested.
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