Britain Will Lose Its AAA Rating, Interest Rates Will Rise & The Property Bubble Will Burst

Britain will lose its AAA credit rating and the resulting rise in interest rates will be the pin that finally bursts the nation’s property bubble. This article examines why this chain of events is all but assured.

Britain will lose its AAA credit rating

Right now borrowing costs in Britain are at the lowest levels since records began in 1703. A 10 year government Gilt (bond), for example, currently yields just 1.774% (well below the rate of inflation). These ultra-low interest rates enable the government to roll over, and issue new debt, incredibly cheaply.

The primary reason for this is the assumption by the bond market that Britain is taking the hard but necessary steps to get its fiscal house in order. As a result Britain is seen as a “safe haven”, especially against the backdrop of the escalating troubles in the Eurozone.

The problem is that the government’s so-called “savage” spending cuts that have been implemented in order to tackle the fiscal deficit are hugely exaggerated.

As the table below shows, public spending actually increased in all but the last financial year, and even then it only fell by 1.5% in 2011-12. The truth is that far from being “slashed”, public spending has hardly reduced at all. Instead the government is relying on increased taxes to reduce the deficit.

UK Public Spending 2008-09 to 2011-12Source: Table based on spending figures and GDP deflators from H.M. Treasury. Note: Figures are in expressed in billion of pounds (GBP).

*Coalition’s first year in office. **Public debt figures are as per the Maastricht Treaty definition.

As this table shows, the deficit has been reduced from £161 billion (at 2010-11 values) in 2009-10 to £123 billion in 2011-12, however it still remains higher than it was in 2008-09. In addition, although real GDP has increased by £40 billion since 2009-10, taxes have increased by £30 billion (at 2010-11 values), which has swallowed up three quarters of the entire increase.

Crucially, far from bringing down our overall level of indebtedness, public debt has actually increased, as has the ratio of our debt to GDP.

To quote Dr Tim Morgan, Global Head of Research at Tullett Prebon, “It seems improbable that the bond markets (and the rating agencies) will continue to fall for this spin-job, and they are likely, sooner rather than later, to call the UK authorities to account.”

Interest rates will rise

Once they realise that Britain is merely paying lip service to serious debt reduction, bond investors will demand higher rates of return for holding our debt, and rating agencies will downgrade Britain’s credit rating as they have with the US, France and others.

The property bubble will burst

Once interest rates on Gilts begin to rise, the higher borrowing costs will quickly be passed on by banks and other mortgage lenders to Britain’s homeowners, resulting in a sharp increase in SVR’s (Standard Variable Rates). This will push many of the 13.6 million Briton’s who are already in arrears on their mortgage payments over the edge, and will likely ensure that many more will join them.

The spike in interest rates will not only put pressure on existing mortgage holders, it will also bring about a tightening of credit that will impact new borrowers, something that will further depress property prices.

One of two outcomes

As far as the bursting of Britain’s property bubble is concerned I see one of two possible outcomes.

  1. Prices fall 30-50% in nominal terms. I.e. from an average home price today of £160,000 to around £80,000
  2. Or more likely, prices will remain flat, or even rise slightly in nominal terms, but fall 30-50% (or more) in real terms. I.e. once you factor in high levels of inflation.

In either case, property prices across the UK need to fall considerably (in some areas as much as 65%) in order to reprice them to sensible, affordable levels.

As painful as it will be, the repricing of Britain’s property market is an essential part of the wider liquidation of malinvestment that is needed before the country can begin a new cycle of true prosperity.

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