I have just finished listening to an interview with Fionnuala Earley, the chief economist at Nationwide Building Society, who today announced a return to double digit annual house price inflation.

The reasons cited for continued strength are:

1.) Continued momentum from 2006

2.) Strong ‘Buy To Let’ demand

3.) Dropping buyer enquiries at Estate Agents offset by low supply

What is startling to me is why no one is willing to call a bubble, a bubble.

Firstly, interest rates have increased three times in seven months to 5.25%, a 17% increase in the interest rate burden. Secondly, first time buyers have all but dried up and the market is being propelled by speculative purchasers seeking to earn capital gains. It is already well documented that yields on ‘Buy To Let’ investment properties are now around five year lows and that it is increasingly difficult to cover interest payments on mortgages using rental income. Thirdly, supply is low, not just due to planning restrictions, but because high prices have disincentivised people from moving home (see this post).

As we saw in the US, it can take years for weaknesses in lending standards to surface and impact on the wider economy. The Telegraph states that “Britain is now one of the most heavily indebted countries in the world…. Total loans amount to 162pc of GDP, compared with 111pc in the US and just 27pc in Poland.” Perhaps this is an indication that below the surface of a buoyant market driven by speculation, cracks will start to emerge.

Watch this space…

“The risk of owning U.S. and European corporate bonds rose the most in 18 months on concern rising mortgage defaults in the U.S. and a slump in Chinese stocks will hurt creditworthiness, according to credit-default swap traders…The iTraxx Crossover Index of 45 European companies jumped 21,000 euros to 201,500 euros at 4:30 p.m. in London, according to Deutsche Bank AG. The index has increased from a record low of 169,000 euros on Feb. 22. The U.S. CDX index surged the most in seven months.”

“The Crossover Index has turned into a gauge of fear,” said Peter Duenas-Brckovitch, head of credit trading at Lehman Brothers Holdings Inc. in London. “Concerns about sub-prime mortgages and a slump in China stocks have fueled the fear, which until a few weeks ago didn’t seem to exist.”

Watch out for hedge fund vulnerability over the coming weeks.

“Rising aversion to other risky strategies, such as the carry trade – where investors sell low-yielding currencies to invest in higher-yielding assets – helped fuel gains for both the Swiss franc and the Japanese yen.

The Swiss franc, which has traditionally been a safe-haven asset at times of heightened risk gained 0.7 per cent against the dollar to SFr1.2215. The yen gained 1.6 per cent to a two-month high of Y118.70 against the dollar, and by 1 per cent to Y157.30 against the euro.”

David Blanchflower commented earlier in the year on how immigration from Eastern Europe was reducing inflationary pressures by keeping wages low thanks to increased labour supply. Furthermore, as wage increases are minimised so too is the pressure to raise interest rates.

This, in turn, helps to increase aggregate demand (low rates + more people = more demand) and create more jobs thus encouraging more immigration. A rise in net immigration will also increase demand for rental properties and mortgages thereby stimulating demand for housing and house prices. There is therefore a double whammy to the housing market as property prices increase and rates are kept relatively low.

What you have to remember, though, is that this current wave of immigration is very different to the waves in the 1950s and 1970s that brought large Afro-Caribbean, Indian and Pakistani communities to Britain. First of all, unlike Asia and the Caribbean, Eastern Europe is nearby and labour can move more freely across Europe since the advent of the EU, secondly, transport and communications are much better and cheaper than they were 50 years ago.

It is therefore possible for this wave of immigration to flow out as quickly as it flowed in. If employment opportunities in the UK trended downwards due to a decrease in consumption, it could trigger an exodus to European markets offering better prospects, e.g. Germany. A reduction in consumption could hit employees in the catering, entertainment, retail and domestic help markets. These are all areas that have benefited from this wave of immigration.

The consequences of the reversal would be a reduction in demand for housing and also a decrease of supply in the labour market. What matters on the latter point is whether labour supply decreases quicker than demand. If it does we could get decreasing consumption, housing demand and increasing wages all at the same time.

At best, the impact is a reduced demand for housing and therefore lower rents or lower house price growth. At worst, wage inflation gathers pace and interest rates increase as well. The latter case is somewhat far fetched but who would have believed, 14 years ago, that the house you were scared of buying could triple in value.

We will see a reversal of these one way bets over the next 18 months. Indeed, I would suggest that, under the surface, this mechanism is well underway and there are a number of factors that may cause the trend to reverse:

1.) Liquidity is decreasing and will decrease further. From a peak of 22% in 2005, liquidity growth has dropped to around 10% ( according to Khuram Chaudhry of Merrill Lynch). So far, this is largely due to central banks increasing interest rates. We have not yet felt the full impact of this, particularly in the UK housing market. Additionally, recent evidence from the US sub-prime housing market and the British credit card/personal loan environment indicate that lenders are taking a big hit as a result of lax lending criteria over the past few years. The offshoot is that financial institutions will tighten lending criteria, further reducing liquidity and will increase bad debts in the process as debtors struggle to either re-pay or re-finance their existing leverage. This could also force disposal of personal assets to cover losses in other areas.

2.) Market confidence will be undermined by increasingly hostile rhetoric between the US and Iran. Both countries appear to be on a collision course. I do not think this will go the whole way, i.e. they will not go to war, but we are going to see things go close. I would not be surprised if this becomes the ‘cuban missile crisis’ of the 21st century. Markets love certainty. The UK equity market bottomed out after the 2001-03 bear market when the US/UK finally invaded Iraq. I posit that uncertainty relating to a US-Iran dispute will shake financial markets, causing a correction but not a crash.

3.) Oil. If 2 is correct, we will see oil over $70 a barrel again and a re-emergence of energy related inflation.

4.) Safe haven currencies. The Swiss Franc has been battered by the carry trade recently. It is at near an all time low with the Euro. Traditionally, when geo-political uncertainty is high, the Swiss Franc is a safe haven. I expect a rapid strengthening of the Swiss Franc over the next 18 months and that this will have impacts for the carry trade. Furthermore, the Japanese economy may be carrying some of its anglo-saxon friends as their debt time bombs begin to unravel. As this becomes a ‘high growth’ economy again, we can expect interest rates to continue to rise and also become a safer haven for investor funds, causing the Yen to strengthen.

5.) Hedge Funds. These firms are highly leveraged and are susceptible should markets begin re-pricing risk. A number of factors could impact here: a large credit default, a strong adverse move in a carry trade currency, collapse in the value of derivatives instruments forcing unwinding of other positions, etc. As seen with LTCM, hedge fund collapses, due to the size of leverage and interconnecvity of these institutions, can have disastrous repercussions across the financial system.

For clarity, I am not predicting the end of the world. I am simply saying that we have lost sight of the fundamentals. A correction is due because there are many one way bets out there that have become self perpetuating due to a combination of cheap money and herd mentality. As a result, we have taken our eye of the ball and not priced risk or assets correctly. Cheap money is being retracted. This has started off the corrective process. Politics will take care of the rest.

The carry trade appears to be a successful bet: as the Yen carry trade grows, the yen becomes weaker as people sell it and the high yield currency strengthens as people buy it. The dynamics re-inforce the profitability of the investment.

The same thing has been happening in the UK property market for some time. Pundits predict rising property prices, people expect property prices to rise so demand increases to “get in before it is too late”, thereby pushing up the prices. The dynamics re-inforce the profitability of the investment.

In both cases, the participants in the markets, be it hedge funds playing the carry trade or buy to let investors buying property, appear to be brimming with confidence. Last week’s increase of Japanese interest rates was dismissed as having negligible impact on the carry trade, as evidenced by the Yen weakening over the course of the week. Similarly, three interest rate rises in seven months seem be to be having limited impact on the UK housing market. Buy to let investors appear to be queuing up despite yields reaching 5 year lows.

Interestingly, the longer this goes on, less and less commentators are willing to predict an end to these one way bets. Those that express concern are quickly called to account by market bulls armed with statistics showing prior claims were unjustified. The cycle becomes self perpetuating as the one way bet removes all obstacles before it.

Except one.

Players in the one way bet will eventually bet, en masse, in the opposite direction. This may be to cash in profits. It may be because of a change in fundamentals or sentiment. What is sure is that these bets have become so large and affect so many people that when they unwind, it will be a messy affair.

One way streets are not designed for two way traffic.

Their logic was simple. The apples come from South Africa. South Africa believes in apartheid. We do not believe in apartheid. We will punish South Africa economically by not buying South African apples. In those days, the apple was a vehicle for attacking an issue.

Today, it is the apple that is the issue and it has lots:

Is it ‘Organic’?

Is it ‘Fair Trade’?

Were the seeds genetically modified?

Was it transported by cart, truck, boat or plane?

Was it grown in a field or in a greenhouse?

What pesticides were used?

Does it come packaged in plastic and bubble wrap?

The number of issues is so overwhelming that it hurts my head just reading them. We seem to have come so far in our knowledge of everything that we crave a return to the most simple of things. An apple that is just an apple. An apple that grew on a tree because a bird dropped a seed that was nurtured by the rain and the sun.

Just like the one that fell on Newton’s head.

Here is the message they left me 4 days ago:

Thank you for creating your petition. It has been entered on our system and will now go to the Number 10 team for approval.

Since then, silence……..

2.) Minimal asset price growth

3.) Popular backlash against environmentally friendly policies

4.) Issues based wars

5.) Emergence of co-operation

6.) Sacrificing the present for a better future

7.) Environmentalism the luxury of the privileged few

8.) Decline of celebrity

9.) Meat production becoming more like wine production

10.) Less travel, not more

I invite you to post your thoughts by clicking on the comments (edit) link above.