Apparently, rates for first time buyers are rising, hitting 7% on some products. I have news for everyone, get used to it. Real rates as charged by lenders will continue to remain well above the official Bank of England base rate for some time.

Let’s have a look at the past 2 years and see what has happened gilts and US treasuries. The following chart shows gilts in blue, with the faint line the curve 2 years ago, the US is the purple lines:

Whilst US rates are lower, especially the short end, the gilt curve is higher and inverted from the 30yr gilt. Over the past 2 years the picture for the UK has not changed, other than borrowing costs are higher.

This has an impact on the UK banks ability to do business. Unlike the US were short end rates have been lowered to cause a steepening yield curve in an attempt to encourage domestic US lending, the UK has no such incentive.

Therefore for UK banks to lend at a profit they have to build their own yield curve steepening by pushing up commercial rates whilst borrowing at the base rate + minimum bp above. For some banks though this is becoming difficult. With LIBOR now pushing well above B of E base rates, as seen here:

The cost for consumers and business to borrow continues to rise. As an aside and to prove my point that falling rates do not help stock markets, you might have fun comparing the above chart to the FTSE.

Even with the B of E cutting base rates, it is noticeable that LIBOR is maintaining the spread that re-occurred in January. Whilst the US has attempted to re-ignite its faltering economy, using Eggertsson’s plan, the UK has taken a different route and is attempting to slow the economy and therefore lower inflation by squeezing economic activity and reduce disposable income, through higher rates and taxes. We are seeing 2 very different approaches to the same problem. Unfortunately, the UK is using the old rulebook and will suffer from the same malaise that stuck at every other self-induced recession.

Even Ben Bernanke has now acknowledged, allegedly, that targeting inflation is fraught with dangers as it restricts policy and flexibility. It’s a shame that the B of E and Mr Brown do not have the vision to see what is coming. By way of explanation I offer you this chart from the B of E Financial Stability Report Summary April 2008:

As you can see the B of E expect the spread between LIBOR and base rates to contract as time goes on. It’s almost like watching someone shorting into an uptrend. Back in October the prediction was for the spread to have almost disappeared by mid 08. In April the same trend of a shrinking spread is called for but with one clear difference, the expectation of the spread disappearing is dropped. Yet in the face of such evidence and their own prediction of a continuing spread the B of E has not moved to protect anything except the banks by introducing the Special Facility.

Spreads occur for a reason, in this case it is a continuing need to price in risk. Even with the introduction of the Banking Sector bailout the risk spread has not reduced. The markets are sending a message that, like the one sent before Northern Rock imploded, is being ignored by policymakers and the Government, even though they recognised such risks in April:

as can be seen in the 3rd paragraph on the right. What is needed is a bit of joined up thinking, a realisation that the forecasts made in April are wrong. Simply put, the increasing burden on consumers as they suffer higher taxation, higher prices and higher interest rates has, in a very short period of time, boosted the risk of a consumer dieback. If such conditions are allowed to continue, the fallout for UK banks will be dire, to say the least.

I expect at least 1 or 2 UK banks that pursued aggressive lending policies to grab market share in the “good years” to fold and join Northern Rock.

Edit. I wrote this on Saturday, I am not sure if B&B qualifies, yet…..

Commentary by Mick Phoenix

on behalf of CA Letters

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.