UK rate cuts could spark another housing boom

June's UK retail sales report from the CBI made for gloomy reading. The CBI's headline index fell to -19 - the lowest it has been in its 22 year history.

The data added further weight to the view that the UK consumer sector is slowing fast. Indeed, with the data looking so weak, it could easily believed that the consumer slowdown will become a consumer crash.

Is the data really that bad? Further inquiry into the underlying numbers suggests not. Firstly, the reason the index hit a record low in June 2005 was partly to do with the fact that activity in June 2004 was, in the CBI's words, 'particularly good', thanks in no small part to the consumer frenzy sparked by the Euro 2004 football championships. Taking the time of year into account, the retail CBI's sales balance was -27: still poor, but better than was seen earlier in 2005.

Furthermore, the CBI pointed out that some retail sectors are doing much better than others. This chimes with the official retail sales data.

Much of the recent weakness seen in the official data is the result of the sharp slowdown in the household goods sector, which has seen growth slow to a standstill following expansion of around 9.0% for much of 2004. Other areas of the high street have certainly slowed, but not to the same extent.

Clearly, the housing market has been key to the growth and resulting slowdown in spending on household goods. To that extent, the outlook for house prices remains crucial.

House price growth slowed to 5.5% y/y in May compared with 19.5% the same time a year ago according to the Nationwide building society, but the pick-up seen in mortgage approvals data - the most recent coming on Wednesday with 95,000 approvals in May - suggests a bounce may be coming. Should that be the case, the outlook for household goods spending, and indeed wider retail activity, will begin to brighten.

Of course, a rate cut would likely further help stabilise the housing market. Over time, growth in house prices is largely determined by the real mortgage rate. A close relationship exists between house price growth and the change in the real mortgage rate over an 18-month period.

Determining the relationship is difficult: rate moves are likely to be a function of house price growth as much as house prices are a function of mortgage rates. However, with financial markets now effectively pricing in 50bps of rate cuts by the middle of next year, its useful to gauge what monetary easing will mean for the housing market.

Here we've approximated the future change in real mortgage rates by extrapolating market's expectation of future base rate moves while assuming inflation stays constant. The result makes for worrying reading. If the relationship between real mortgage rates and house price growth continues to hold, rate cuts later this year could mean house price growth back in excess of 10% y/y by the middle of next year.

In its last meeting, two of the nine members of the Bank of England's Monetary Policy Committee voted to cut rates. Their concerns are understandable: the key consumer sector is indeed fragile, other areas of the economy are not performing, and the housing market still looks shaky.

However, despite slow growth now, there remains the strong possibility that easing rates soon could spark off the housing boom again. That would be ironic given that one of the major reasons for beginning on the hiking cycle in the first place was to end the boom once and for all.

For that reason we are sticking to the view that the first rate cut should come early next year, later than markets expect. Though with some of the MPC clearly advocating easing soon, we understand why some feel that a rate cut could come by August.