Interest rate rises are the biggest threat to UK house prices

A lot of housing analysts have focused on austerity and rising unemployment as the major risks to the UK housing market. But there is a more obvious risk that few are considering, namely that efforts to keep interest rates down will fail miserably.

At the moment confidence is fairly high that the Federal Reserve and its UK counterpart the Bank of England can keep a lid on interest rates by a process known as quantitative easy which is best seen as a centuries old government trick called printing money.

Money printing

The idea in essence is that enough money is printed to suppress the cost of money. In short, you supply more money to keep the price down.

The mechanism used to expand the money supply is the bond market. But problems arise when inflation begins to rise and the returns paid on bonds are not high enough to compensate bond holders. Last week we saw the first inflation-linked bonds to have a negative coupon in the US, and investors only bought them in the belief that inflation is on the way up.

Where does that leave all the holders of conventional US treasury bonds or UK gilts? If inflation takes off then the paltry yields they are paid mean that they make a loss after inflation. It is worse than that. For the price of the underlying bonds will fall automatically as markets start to demand higher yields.

That is what is happening to bond holders in Ireland, Spain, Portugal and Greece right now. Interest rates are rocketing upwards. It is only a matter of time until the bond vigilantes pick on the US and UK and the same thing happens.

Marc Faber

The investor voted the fifth wisest in the world by a Bloomberg poll, Dr Marc Faber thinks this will happen ‘within a few months’ (click here).

If he is right then UK mortgage rates will start to move up from their current record lows. That will put a further squeeze on an already very fragile UK housing market. But this is nothing new to housing markets and it is amazing that so few analysts have even considered this possibility.

Normally housing markets hit the bottom with interest rates at a high point, not at a low-point as they are at present. Normally such low interest rates would be seen with house prices at a peak.

What is so artificially high has a long way to fall as interest rates revert to more normal levels, and the bond market undergoes a huge correction (click here).