Mortgage experts signal rates pressure may ease

Aug 29 2007 by Sarah Davies, Liverpool Daily Post

HOMEBUYERS were offered some relief last week as a host of mortgage lenders cut the cost of fixed rate deals, providing a clear signal they believe that interest rates may now have peaked.

Nationwide reduced its two- year fixed rate deal from 5.83% to 5.78%, following similar moves from Britannia, Royal Bank of Scotland and Halifax.

Falling inflation figures, a slowdown in consumer spending and the recent turmoil in equity markets have all added to speculation that further hikes could hinder the economy, but opinion is still mixed.

A sharper-than-expected drop in inflation during July saw the Consumer Prices Index (CPI) drop from 2.4% in June to 1.9% – the first time inflation has stood below the Bank of England’s 2% target since March last year.

The news followed hot on the heels of the Bank’s August inflation report which indicated rates would need to rise one more time to 6% before the year end.

But the weaker inflation figures overturned these predictions and speculation mounted that perhaps interest rates have peaked at 5.75%.

This will benefit would-be borrowers looking for fixed rate mortgages as lenders introduce cheaper deals on the back of reduced expectations of further rate hikes.

It should also help those coming to the end of cheaper fixed-rate mortgages. According to the Council of Mortgage Lenders around 1.3 million households are set to come off fixed-rate deals this year and can expect to see an extra 1.5% added to the cost of a new deal.

Despite the five interest rate hikes in the last year, fixed rate mortgages remain the most popular mortgages with an estimated 78% of new mortgage holders opting for a fixed rate deal in June.

Lenders base their deals on "swap rates", or the cost of borrowing funds from another bank, which are, in turn, based on base rate forecasts.

Melanie Bien, of Savills Private Finance, said: "Lenders have been reducing their two-year fixed rate mortgages on the back of swap rates.

"Two-year swap rates have been falling, down from 6.13% a week ago to 6.04% after the sharp fall in inflation last month." Some brokers also recommend that now may be the time to switch to tracker mortgages, as even if interest rates were to rise one more time, many deals could work out to be cheaper than a fixed rate loan.

The cuts in fixed-rate mortgages will not benefit all homeowners.

The surprise fall in inflation came in the midst of recent turmoil in equity markets following the collapse of the US sub-prime mortgage market, which lends to people with poor credit histories.

The fall-out from the sub-prime crisis caused lenders and investors to reassess the risk premium associated with debts.

Where credit has generally been very easy and lenders have been relaxed about risks, particularly in the sub-prime market, this risk is now being re- priced resulting in tighter credit markets.

This makes riskier lending and short-term rates more expensive with specialist mortgage lenders forced to increase their rates to cover costs. This could well see some would-be homeowners with poorer credit ratings priced out of the housing market.

Meanwhile, mainstream banks lending to "prime" customers are able to offer reduced fixed-rate products, whilst also taking advantage of the current climate to build up their customer base, particularly given recent falls in mortgage approvals. Ms Bien said: "Mortgage lenders like Halifax have been struggling with market share over recent months. Reducing their rates can help them bring in more customers.

"While shorter term borrowing rates have shot up lenders are choosing to absorb these higher borrowing costs in the short term, but if the situation continues in the longer term they would then raise rates."

The recent turbulence on equity markets has also added to expectations that a further interest rate rise is now unlikely, at least in the short term.

Commercial lending rates, for companies, households and individuals, are now higher in comparison to the Bank of England’s base rate.

Where the Bank has previously raised interest rates to rein in borrowing and spending, the credit markets will now do this.

Geoff Dicks, UK economist at Royal Bank of Scotland, said: "In effect, the tighter money markets are now doing the Bank of England’s job for it."

RBS is still expecting a further rate hike, but has shifted its forecasts to November.

Ray Boulger, senior technical manager at mortgage broker John Charcol, said: "The tightening credit environment will see the economy slow down as will merger activity. It will be more difficult to put mergers together as it is more difficult to get finance."

Mergers and acquisitions have been a main market driver over the last year, boosting the financial services sector which is a strong contributor to economic growth. A slowdown in this area will dampen overall activity and reduce the need for higher interest rates.

While arguments regarding peaked interest rates look relatively solid, some analysts caution that the situation may not be that simple.

The drop in inflation in July was largely credited with falling food prices following a supermarket price war which has seen Tesco and Asda slash prices.

But the severe flooding in July and the foot-and-mouth scare in August could lead to a sharp rise in vegetable, dairy and meat costs, while an ongoing global wheat shortage is also set to keep impacting on the cost of cereals, bread and animal feeds.

In a recent report on the UK economy, Mr Dicks said that supermarkets had initiated a "sea-change in pricing behaviour".

Higher interest rates have hit heavily-indebted households, which has caused suppliers and retailers to cut back prices.

Mr Dicks said: "Where a year ago supermarkets were competing on premium/organic products, the whole emphasis of their marketing campaigns has switched to price.

"We believe this is not just a temporary phenomenon but is likely to persist in the face of the squeeze on households budgets."

Even if vegetable prices rise following the flooding, Mr Dicks believes it will be offset elsewhere.

The Bank has also been concerned about firms’ ability to raise prices but a recent industrial trends survey from the CBI showed that manufacturers are now less confident about their pricing power than during the first half of the year.

Malcolm Barr, UK economist at JPMorgan Chase Bank, said: "It is too early to say with any degree of confidence whether interest rates have peaked.

"We are approaching levels at which it may be possible to think interest rates may stabilise or at least rise more slowly but the bias is that risks are still to the upside."