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Rising Interest Rates & Housing

The property market depends for its wealth effect on interest rates. They are rising. But how far will they rise? And if they rise much further, what will that do to other debt, such as government debt, and company debt? Are we heading for a financial meltdown if the first happens, and/or a business meltdown if the latter?

On the other hand, are we heading towards a global systemic financial collapse, and a reset? And what the heck would that mean?

Some serious questions. Can we try and work thru some probable outcomes?

That's entirely possible, but what I think is not possible is to predict how the final cock-up is resolved. And working through this is not going to take one short blog entry. But let's get started.

What is beyond doubt is the fact that banks have been expanding credit like there's no tomorrow, and central banks have been printing unbelievable amounts of money. That has led to a world economy based upon debt, plus a dilution of the value of currencies. These two activities have in turn led to several situations which are all fine and dandy so long as the rules dont change. But they do, and they have changed.

If inflation hovers around 1% and interest rates are even a smidgeon below that rate, and the economy is chugging along quite nicely, everyone is happy. What is there not to be happy about? I can borrow money at 3.5%, invest it, and make anything from 7% and up on relatively safe investments. I'm increasing my wealth by 3.5% or more a year. With inflation only at 1% I'm a happy bunny ending up by 2.5%.

Sadly, all those maths implode when inflation starts going berserk. Let's do the sums again.

I can borrow money at 3.5%, invest it, and make anything from 7% and up on relatively safe investments. I'm increasing my wealth by 3.5% or more a year. But with inflation now at 10% I'm getting poorer by a worryingly large margin. Result? I am a very unhappy bunny.

What we now have is businesses having to pay seriously increased costs for the money they've borrowed. House owners are in the same situation. And so are governments. And this is where it gets tricky.

For the home owner, the maths are disarmingly simple. That 200,000 mortgage which used to cost, say 4%, was equivalent to 4,000 a year, or 80 a week. If interest rates only double to 8% that is a serious increase in the daily outgoing. And that rate would still be 2% below the inflation rate, which means it isn't properly compensating for the real cost of lending out the money in the first place. So why would the lender lend? I certainly wouldn't.

For a business, the increase in the cost of money borrowed would obviously impact on the prices a company would have to charge on its goods in order to continue to make a profit. This will naturally feed through to the consumer price index, and that will show a further rise in inflation, which will mean the lender will need more compensation for lending. Who wants to lend 1,000 on january the first this year, if the return on january 1st next year is only 4% when inflation is running at 10%?

The maths are relatively simple regarding house prices. To compensate for the depreciation of the currency, the cost of the money goes up, and so the home owner is under pressure, and may be forced to sell if he can't keep up the increased payments. That will put pressure on house prices in general. It will also mean that prospective purchasers will have to consider whether an increased interest rate is payable before they make an offer on a house. If more money goes on interest, less goes on repaying the mortgage, which means the average home purchaser will have to lower his offer to buy in order to stay solvent. The above scenario would put recent home purchasers under water. We now have the beginnings of a tanking housing market. And that is what is coming.

For businesses the same circumstances are about to hit hard, probably leading to a surge in bankruptcies caused by companies' inability to service the debt they have taken on. What was payable last year is increasingly not payable this year. And what about next year?

An increase in companies going bust is going to lead to more people unemployed, and therefore more people unable to pay their mortgages, leading to more forced sales, and more downwards pressure on house prices.

What most people dont seem to realise is that all these circumstances are not confined to mortgages and business debt. What happens when banks have to deal with this situation? And, more importantly, where does that leave governments with their ridiculously bloated budgets?

I'll delve into those murky waters next week.



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