The impact of a change in interest rates on Irish mortgage holders

The Irish Central Bank publishes data on retail interest rates on  a monthly basis and the rate on new mortgage lending receives much media attention, given that  it is significantly above the euro average (3.21% in March against 1.81%). Far less attention is paid to the average rate on existing mortgages  ( 2.6% against 2.23%) although that is the relevant figure when one is  considering the vulnerability of Irish debtors to a rise in interest rates, given the preponderance of floating rate debt.

New borrowers are turning to fixed rate loans in much greater numbers, with over half of new mortgages at fixed rates in the first quarter of 2018, but that is low relative to the euro average ( over 80%)  and has little impact on the stock of outstanding debt, which is still heavily weighted to floating rates. For example, some €60bn of the mortgage debt owed to Irish banks in the first quarter was at a floating rate , or 81%, against under €14bn at a fixed rate.

That also means that most  mortgage holders have seen a massive fall in monthly payments over the past decade, as the average mortgage rate was 5.3% in mid 2008. The scale of deleveraging since then has also helped to reduce the total   simple interest paid monthly on outstanding mortgage debt  to Irish lenders, which is currently under €2bn a year against €6.3bn ten years ago. Of course, the corollary is that interest paid on deposits has also fallen substantially, highlighting that any interest rate change is a transfer between saver and borrower.

Most analysts now believe we are at the bottom of the interest rate cycle in the euro area and the ECB will start to raise rates at some point, probably in 2019, although the precise timing is open to debate given the absence of any clear upward momentum in core inflation. How would a rate move affect mortgage holders, if and when it comes?

The average  interest rate on existing mortgages which are not fixed is 2.3%, which is biased downward by the proportion of tracker rates ( still over 40% of the total, although falling)  where the average rate is just 1.07%. These are linked to the ECB’s main refinancing rate (curently zero) and would not change if the ECB raised its deposit rate ( the most likely first move) although that would push up money market rates and hence standard variable rates ( and lead to higher fixed rates for new borrowers). An increase in the refinancing rate would however be required before all existing floating rates rose .

Although there are only some €75bn of mortgages on the books of Irish lenders the outstanding stock is just over €100bn given securitisation and sales, which implies about €81bn or so would be impacted by a rate change is we assume the same ratio of floating to fixed.The precise effect for each borrower would depend on the maturity of the outstanding debt but if we assume an average 15 years ( most existing mortgages were taken out in the early to mid noughties)  a 1% rise would increase payments by  just under €0.5bn a year, substantially more than the tax reductions in the 2018 Budget ( €335m).

Of course higher rates would also have an impact on interest rates on deposits accounts , although the precise effect would depend on whether bank margins also changed. However, although total household deposits are also up around €100bn,  some 80% are  overnight  and earning next to nothing  leaving total interest paid by Irish banks on household deposists at just €160m a year.

Rate changes generally have a bigger effect on borrowers than savers anyway and so the implication is that  Irish household  spending would still be significantly affected by a rise in interest rates  despite the recent increase in fixed rate borrowing and the deleveraging seen over the past decade.

 

Hitting the (Capital) Buffers

International regulation of financial institutions changed considerably in the aftermath of the 2008 financial crash. Banks are now required to meet certain ratios in terms of liquid assets as well as holding more capital in the form of equity in order to better absorb unexpected losses. Some institutions are also deemed to be systemically important, be it by virtue of global size or their significance in the domestic economy, and therefore required to hold additional equity in order to ameliorate the ‘too big to fail’ issue.

Banking tends to be very pro-cyclical and regulators have introduced an additional capital requirement which is adjustable over the economic cycle. This counter-cyclical buffer (CCyB) can be increased in an economc upswing when credit growth is strong, in order to act as additional support when credit losses start to appear, and released in a downturn in order to prevent a rapid contraction in bank lending.In the euro area the local regulator, in our case the Central Bank, is  designated to determine the size and timing of the buffer, which can range from zero up to 2.5% and is set quarterly ( a bank would then have twelve months to meet the CCyB)

What determines whether the buffer is triggered? In effect the Central Bank  has ‘guided discretion’ with emphasis placed on the stock of existing credit to GDP ratio relative to its long term trend (the’Credit Gap’). In Ireland’s case the ratio exceeded 400% at the peak  but has fallen sharply of late, down to 260% at the end of 2017, reflecting deleveraging by the private sector and the surge in nominal GDP. Consequently the ratio is low relative to the trend and as such would argue for a zero capital buffer, which has indeed been the case since it was first introduced in 2016.

Indeed, the  negative credit gap in Ireland is very large ( the current ratio is 75% below trend) which implies it would take years before it closes even with a resumption of positive credit growth, and therefore years before that measure would trigger a rise in the counter cyclical buffer, However, the Central Bank has recently drawn attention to the rise in new lending  and noted in its most recent review of the buffer (in March) that ‘it could … be the case that the Bank sets a positive CCyB rate prior to the credit gap measures indicating the need to do so‘.

In that context it was interesting that the Bank has just published research here   on the ratio of new mortgage lending to household disposable income. That ratio exceeded 30% at the peak of the boom and then collapsed to a low of 2.5% in 2011 before recovering in recent years and  is currently at 6.7%. Is this too high? The average ratio going back to 1998 is over 13 so that would not indicate a problem but of course the average includes periods where credit standards were very loose. The research piece attempts to answer the problem by estimating a model based ratio, driven by structural factors such as long term interest rates, demographics and an index designed to measure the effectiveness of the financial and regulatory system( the latter two prove to be the key drivers).

In fact the model throws up a current figure close to the existing ratio, and although the growth of new lending is slowing it still exceeds income growth, with the implication that the ratio will continue to rise, albeit at a slower pace. So this new emphasis by the Bank on the flow of new lending as opposed to the stock of existing  private sector debt  may in time be used to justify a rise in the CCyB even though the standard Credit Gap would argue against.

Irish housing transactions fall in q1 with cash buyers still dominating

The CSO’s Residential Property Price index for March showed prices still accelerating nationally, with the annual change at  12.7% from a downwardly revised 12.5% in February and 12.1% at the end of 2017. Property price inflation in the capital slowed, to 12.1% from 12.6% the previous month, but picked up strongly over the rest of the country, to 13.4% from 12.3% . Prices  were particularly strong in the mid-West (Clare, Limerick and Tipperary), rising by an annual 16.4% but fell for the second consecutive month in the Border counties, reducing the annual gain to 8.8%. Within Dublin, house prices in the city rose by an annual 14.2%, with South Dublin lagging, showing  a rise of 9.6%.

The housing market is generally perceived as characterised by chronic excess demand although the exact amount of new supply (house completions) is subject to some doubt. The number of housing transactions is available though, through the CSO, and the figure for the first quarter is actually down on the previous year, at 13,967 versus 14,500. The decline in turnover was particularly acute in Dublin, with transactions down 10% to 4,500.

The number of mortgages drawn down for house purchase in q1 , at 6,400 , was up by some 10% on the previous year, but that still implies that over half the transactions in the quarter (54%) were financed by non-mortgage buyers, a persistent feature of the market. First time buyers account for more than half of loans but are clearly competing against investors, both corporate and individuals, as well as each other, for the limited supply available.

Moreover, the approvals data, a leading indicator of drawdowns, indicates that lending is actually slowing, and quite sharply; approvals in q1 were  down on the previous year, by 4%, and by 13.7% in March alone. We have noted before that the Central Bank’s latest modifications to their mortgage controls, which took effect this year, was an effective tightening, as only 20% of FTB loans can exceed the 3.5 LTI limit , as opposed to an actual 25% last year. Indeed, new  mortgage lending was offset by redemptions and repayments in the three months to March. In other words net lending was negative and with new lending slowing and accounting for less than half the transactions in the market it is hard to argue that prices are being fuelled by credit. Rental yields in excess of 5% is obviously attracting buyers in a QE driven environment of zero short rates and  10 year bond yields of under 1%.

Irish net mortgage lending falls again in Q1 and approvals also decline.

In the autumn of last year the flow of new mortgage lending  in Ireland started to offset repayments and redemptions for the first time since early 2010 and the annual rate of change turned (marginally) positive in January. Net bank lending to the non-financial corporate sector also began to pick up, although again the annual rate of growth was barely above zero, albeit adding to the view that the credit cycle was turning. The latest figures, to end-March, cast  doubt on that however, as net mortgage lending rose in the month but contracted by €28m in the first quarter. This still left the annual growth rate in positive territory , albeit at an unchanged 0.2%, but the annual change in corporate lending turned down again, at -0.3%, following a €365m decline over the first three months. Consumer credit, boosted by car purchases, had been growing strongly but has also softened, declining for four straight months in cash terms  reducing the annual  rate of growth to 2.4% in March.

New mortgage lending is still growing, of course, amounting to €1.7bn in Q1, with €1.4bn  of that used for house purchase, but the pace of growth in the latter is slowing. particularly in terms of the number of mortgages drawn down. That figure was 6,400 in the first quarter, which represents a 9.6% increase on the previous year , compard to a 14.7% rise in the previous quarter and 26% growth a year earlier. The latter pace is clearly unsustainable and some easing was to be expected but the approvals data paints a more disconcerting picture; approvals for house purchase in March fell by an annual 13.6% bringing the annual decline in q1 to 4%.

The shortage of houses for sale is no doubt impacting ( transactions fell marginally in the first two months of 2018 compared to a year earlier) while the Central Bank limits on lending may also be a factor, particularly the Loan to Income restriction which is particularly relevant for First Time Buyers.  The average mortgage for house purchase rose by 22% in the three years to end-2017, against just a 4.4% rise in average pay, with house prices rising by 31% over the same period.

There is clearly an affordability issue developing, exacerbated by the spending power of non-mortgage buyers,  who see housing as an attractive asset class in a QE world of expensive equities and historically low government bond yields. The weak credit environment is also an ongoing issue for the Irish headquartered banks; total loans continue to fall, declining to under €176bn in March,  a fresh cycle low, and exceeding deposits by some €8bn. The Central Bank has expressed some concern about the pace of new lending in recent months but the issue facing the economy and the banking sytem in terms of net credit is very different.

2018 Budget now seen as pro-cyclical and breaking EU fiscal rule.

One of the standard criticisms of Irish economic policy is that tax and spending changes in the Budget tend to be pro-cyclical  i.e. the government of the day is often adding spending power to an already buoyant economy. This may be due to mistakes in estimating economic activity or simply reflecting what the electorate appears to want- higher spending and/or lower taxes. There are EU imposed constraints now, of course, designed to limit how much the government can inject into the economy , but these rules apply to the budget as adjusted for the economic cycle, as opposed to the headline balance, and that can throw up some odd situations for Ireland, given the volatility in our GDP.

It now appears 2018 will provide a good example of an Irish Budget which was deemed in line with the EU rules but now appears in breach. When presented, in October last year, the economy was  thought to be operating  well above capacity by the EU but the expected growth rate of 3.6% in 2018 was seen as  below the economy’s potential growth rate ( 4.5%) so reducing the output gap somewhat, albeit still leaving it in postive territory. So although the actual fiscal deficit was forecast at 0.2% of GDP  the cyclically adjusted (or structural)  deficit was actually higher, at 0.5%, given the (EU) view that the budget was being flattered by a buoyant economy. However, this was still deemed to be acceptable as the structural deficit  as forecast was seen to be falling from an estimated 1.1% of GDP in 2017, hence meeting the EU rule as well as being net contractionary in terms of its impact on demand in the economy.

Today’s release of the annual Stability Programme Update (SPU) by the Department of Finance shows a very different picture. Growth in 2018 in now forecast at 5.6% ( over 2 percentage points higher than in the Budget) and also 0.9% above the estimated potential growth. As a consequence the economy in 2018 is now seen to be operating 1.2% above potential ( the 2017 output gap was also revised) and although the headline deficit forecast is unchanged at 0.2% of GDP, the structural deficit is now much higher, at 0.9%. Moreover, last year’s structural deficit is now put at only  0.4% of GDP so on the face of it Ireland’s strucural deficit is actually rising by 0.5% of GDP instead of falling by a similar amount, as per the preventive arm of the Stability and Growth Pact. This is not only  a breach of EU rules but also indicates that the Budget is adding net spending to an economy already operating above capacity.

Any breach of EU fiscal rules is unlikely to mean much as there does not appear to be the political will in Brussels to rigorously enforce them. The Department, and others, would also argue that the output gap measure used above is wrong and that alternative measures still show the economy  still with some, if rapidly diminishing , spare capacity. Indeed, Finance expects the unemployment rate to continue to fall before bottoming out at 5.3% in 2020, which is not consistent with  the headline output gap measure. Regardless of the precise measure used, it does seem that the economy is operating at or close to capacity and so the old arguments about pro-cyclical policy are likely to resurface ahead of the 2019 Budget, albeit with little impact on the final outcome.

 

Criticism of Irish National Accounts overdone.

The recent release of Ireland’s national accounts for 2017, showing a (preliminary) increase in real GDP of 7.8%,  precipitated another round of complaints about the relevance of such data, including  ESRI comments calling for a ‘parallel’ set of accounts to be published, stripping out the impact of   the ‘large transactions of a select number of firms’.

In fact the CSO already publish a number of adjustments, following  the clamour accompanying the release of the 2015 accounts, which were  the first compiled under the new EU standard, ESA 2010,  prompting some to talk of ‘leprechaun economics’.  A modifed capital formation figure is produced in the quarterly accounts which strips out two components- aircraft leasing expendidure is excluded from total spending on machinery and equipment and R&D spending on intellectual property service imports is excluded from total spending on Intangibles. The latter is GDP neutral anyway (investment  boosts GDP but if imported will have an offsetting negative impact)  but Intangibles has contributed to a huge increase in the investment share of GDP, as well as being extraordinarily volatile on a quarterly and indeed annual basis. This adds to the difficulty of forecasting Irish GDP but, nonetheless,  is the internationally accepted norm in that such intellectual property  used to be viewed as a cost of production but is now (rightly ) deemed to be an asset , be it dometically generated or transferred from abroad.

The CSO  has also introduced a  modified Gross National Income (GNI) figure , GNI*, albeit only published with the full annual accounts, and one wonders if this was embraced too readily. This concept is unique to Ireland and  makes a number of adjustments to the  headline GNI figure, largely reflecting the depreciation of intellectual property assets and aircraft  as well as excluding the profits of  firms re-domiciled in Ireland.Yet it is unclear what the final figure is supposed to mean and the adjustments are arbitrary, (why aircraft leasing, for eample, which has a long history in Ireland, and are firms domiciled here or not?) as well as confusing in that the term  ‘gross’ is still used, even though  some depreciation is  excluded.  Indeed, if depreciation is the issue why not simply use Net National Income (NNI), which adjusts for total depreciation across all sectors, and  has always been published on an annual basis. Moreover, the correlation between NNI and GNI* on the  annual data going back to 1995 is extremely high , at 0.99.

GDP is the internationally accepted norm, of course, and closer to home  most people would view the debate as arcane. Other readilly available indicators exist that are of  use in capturing real developments in the economy depending on the question asked. The surge in employment in recent years  and the plunge in unemployment is real enough for many households, as is the increase in household incomes. Similarly we can track consumer spending in the national accounts. Some argue that the GDP figure , when used as a denominator, gives a misleading indicator of Ireland’s debt burden, but again there are other metrics which one can use, including debt to tax revenue. Another perceived problem is in relation to forecasting for the Budget, but that is done on a bottom up basis anyway by the Department of Finance  i.e. income tax receipts reflect employment and pay assumptions and VAT  forecasts depend on consumer spending projections.

The change to a new methodology in collating the national accounts had a huge impact on Ireland’s recorded GDP, but this was a step adjustment and need not lead to  a host of ad-hoc exclusions, while any volatility going forward reflects the scale of multinationals relative to the indigenous economy and hence a fact of modern Irish life. Real growth in the latter part of the 1990’s averaged over 9% per annum, driven by multinationals, so the average over the last two years ( 6.5%) is not that unusual. It is also curious that the the Irish authorities spend an inordinate amount of time defending the multinational presence in Ireland as real,  yet also devote time and effort in producing arbitrarily  adjusted GDP figures to strip out part of that multinational impact.

7.8% Irish GDP growth in 2017 but consumer spending up only 1.9%.

The Irish economy grew by 7.8% last year in real terms according to the initial CSO estimate, bringing the cumulative increase over the past three years to 45%. Nominal GDP in 2017 grew by 7.5%, to €296bn, and is now over €100bn larger than it was in 2014. Those kinds of numbers are clearly extraordinary and indicate some serious distortions, as consumer spending is now less than a third of real spending in the economy ,against an EU norm of over 50%, while the surplus on the Balance of Payments in 2017 was recorded  at €37bn or 12.5% of GDP, and 19% of GDP in the final quarter alone.

Indeed, consumer spending was surprisingly weak in 2017 given what we know about household incomes; employment  rose by 61,000 or 2.9%, and average pay increased by 2%  yet personal consumption grew by  only 3.2% in nominal terms and  by 1.9% in real terms, implying a significant rise in the savings ratio. The latter is also out of kilter with surveys of consumer confidence, which have hovered around record highs.

Building and Construction is growing strongly, rising by  over 16% last year, spurred by a 33% increase in housebuilding. Spending on machinery and equipment fell however, by 11%, and by slightly more when account is taken of aircraft leasing, but overall capital formation was again dominated by multinational spending on Intangibles ( R&D, patents) which fell by 41%  following a 111% rise in 2016. As a result overall investment fell by 22% and final domestic demand declined by 8%.

The plunge in recorded R&D spending is broadly GDP neutral as service imports also fell , contributing to an  decline in  total imports of 6.2% in volume terms. On the export side contract manufacturing was again a major influence, with merchandise exports in the national accounts recorded at €194bn, as against €122bn actually manufactured in Ireland. Service exports rose by over 14% , and exports as a whole rose by 6.9% in volume terms.

So on the face of it the external secor made a positive contribution to 2017 GDP growth of some 15%, so dwarfing the big negative from domestic demand, with an additional 1% coming from a strong stock build.

On a quarterly basis, the seasonally adjusted data reveals a very strong second half to the year, with real GDP expanding by 3.2% in the final quarter following  4.8% in q3, although again personal consumption is seen as surprisingly soft, increasing by just 0.3% in q4. That skewed pattern also left the annual increase in GDP in the final quarter at 8.4%, which in a normal economy would indicate that growth in 2018 would likely be extremely strong given that base, but in Ireland’s case one can’t be as sure, such is the extreme volatility from quarter to quarter.

Powell Rules

There’s a new kid in town. Jay Powell’s first major speech as Chair of the Federal Reserve, the Monetary Policy Report to Congress, had an immediate impact on markets, interpretated as indicating a more hawkish stance than his predecessor. Time will tell but one interesting feature of his speech was his emphasis on monetary rules in setting policy, which  he finds ‘helpful’, with an analysis of five such rules detailed in the Report.

It seems clear that the Fed do not slavishly follow any rigid precription in setting interest rates, although the rate paths implied by the various rules  are apparently set out ahead of FOMC meetings in order to act as a guide, and Powell’s speech is likely to stimulate further market interest in this area.

The best known rule is named after John Taylor , and posits that the Fed funds rate should move by precribed amounts from its long run equilibrium level  ( which on current FOMC forecasts is 2.75%) if inflation differs from the 2% target or if the real  economy  has moved away from its full employment level, which the Fed currently believes is consistent with an unemployment rate of 4.6%.

What does the Taylor rule imply now? The Fed expect inflation in 2018 to pick up to 1.9% but that the unemployment rate by the final quarter of the year will have fallen to 3.9% and so below the long-run equilbrium level , indicating that tighter policy is required, with an implied  Fed funds rate of 3.3%, which is around 1% higher than the median FOMC expectation as set out in the ‘Dot Plot’.  In other words rates would rise more rapidly than curently envisaged by the market , although over the following few years the ‘Dot Plot’ converges to the Taylor rule, albeit with the latter implying a modest easing of policy while the former points to a steady tightening. The Taylor rule also implied the need for negative rates following the financial crash and an “Adjusted Taylor rule’ take account of this insufficient monetary accommodation in the past by advocating a gradual return to the rate implied by an unadjusted Taylor rule, although the former has now largely converged to the latter.

What of the other rules discussed? A ‘balanced Approach’ rule gives a greater weight to deviations from full employment and that also indicates that policy is too accommodative, and indeed should be much tighter by end-year, with a Fed funds rate of 4%, before falling back to 2.75% in the long run.  Not all rules imply the Fed is behind the curve, however, with the other two rules discussed arguing against aggressive tightening. One, the ‘First Difference rule’ takes account of the current level of the Fed funds rate and the pace at which unemployment is changing, and implies a policy rate of 1.75% by end-year, which is below the ‘Dot Plot’ figure . Similarly, another variant, ‘the ‘Price Level rule’, implies that policy is also too tight now and as projected because the rule adjusts for the fact that inflation has been below the 2% target for some time, so the price level is therefore lower than would be the case had inflation been at 2% every year.

All such rules are based on simplified models of complex  and changing dynamics in the US economy, but ,as Powell noted, can be useful for policy makers . Three of the five imply that rates are too low given the Fed’s expectations for inflation and unemployment which may prove more significant with Powell at the helm.

 

Modest rise in Irish pay in 2017, led by public sector

Pay growth has been modest by historical standards across many developed economies in recent years, despite tightening labour markets, and Ireland is no exception- average weekly earnings  only started to rise again in 2014, and average  annual increases of around 1% have been the norm. Unemployment peaked in early 2012  at 16%, and has been falling steadily since, declining to 6.2% at the end of 2017, so one might expect that firms would have to increase pay to attract and retain labour.

Average weekly earnings did pick up through 2017, according to the latest CSO data, rising by by annual 2.5% in the final quarter of the year, which brought the annual average increase to 2%. The growth in private sector earnings last year was lower, at 1.8%, and was outpaced by the 2.6% average rise in the public sector. Pay in the latter is on average 41% higher than in the private sector, but has generally lagged since 2008, when the differential was 46%.

Average pay masks large differentials across the various sectors in the economy and the the recovery has been kinder to some workers than to others; the earnings of workers in Information and Communication, Scientific and Professional services and Adminstration and Support have all  significantly outstripped the average growth in pay, while the Financial sector has recently recorded strong pay growth after steep falls during the recession. Surprisingly, perhaps, pay in construction is not as buoyant as one might imagine, with average earnings barely increasing in 2017 and still below the 2008 level.

Consumer prices rose by only 0.4% last year so a 2% pay rise translated into a 1.6% increase in real earnings. Nominal pay growth is generally expected to accelerate in 2018, given the further erosion of slack in the labour market, although, as seen elsewhere, the traditional relationship between unemployment and pay growth, the Phillips Curve, has become much flatter,

 

Irish new mortgage lending rises by 29% in 2017 but affordability is deteriorating

Irish mortgage providers lent €6.4bn for house purchase in 2017, the strongest figure since 2008, with top-ups and re-mortgaging bringing the total to €7.3bn, a 29% increase on the previous year The final quarter was particularly strong, when adjusted for the usual seasonal effects , and we expect further growth in 2018, although affordability is deteriorating and the Central Bank’s modifications to its mortgage controls will no doubt have some impact on First Time Buyers , as Loan to Income is the main constraint for that segment of the market. Indeed, there was a notable slowdown in approvals in the last few months of the year, perhaps indicating that lenders are already adjusting to the rule changes.

Drawdowns were very strong in the final quarter, nonetheless, with over 8,700 mortgages for house purchase including over 5,000 to FTB’s, some 60% of the total. For 2017 as a whole 29,400 mortgages for house purchase were drawn down, still a far cry from the boom figures in excess of 100,000 but significanttly above the low recorded in 2011 (11,000) and 18% above the total in 2016. The value of lending for house purchase implies an average mortgage of over €217,000, against €200,000 in 2016, and a cycle low of €174,000 five years ago.

Interest rates on new loan have not materially changed over that period and household incomes have risen but the increase in mortgage size is such that affordability, the ability to service a mortgage, has deteriorated. Our own model compares  the annual cost of a new , 25-year repayment mortgage to our estimate of gross  borrower income, and shows that the ratio rose to 30% in 2017, the highest since 2009 and above the long run average (back to 1975)  of  29.5. The ratio is still well below the heights recorded at the peak of the boom ( over 40%) but our forecast is for a further deterioration in 2018, to 31.2 , and this assumes no change in interst rates, so any rise in the latter  would indicate a greater deterioration.

At the moment a rate rise looks unlikely until 2019, at least, and the affordability change expected does not look material enough to have a significant impact on lending, given the prospect of further gains in employment, an acceleration in wage inflation and stronger house completions. Against that, the Central Bank’s changes to mortgage controls are undoubtedly a policy tightening, in our view, although not  sufficient to prevent further growth in new lending, and we anticipate a figure around €9bn in 2018. Net lending has also started to grow in recent months, so the coming year will probably see the first rise in Irish mortgage debt in a decade.