Irish Central Bank tightens mortgage controls

The Central Bank introduced macroprudential controls on Irish mortgage lending in early 2015 with a focus on Loan to Value (LTV) and Loan to Income (LTI). The controls are subject to annual review and were initially amended  in January 2017 with  another set of ‘refinements’ just announced , to take effect from 2018.The latter includes quite a significant modification to the way the LTI control operates and in our view represents a tightening of credit controls, although one does not get that impression from the Central Bank release.

Currently, 20% of Principal Dwelling House (PDH) lending can exceed the 3.5 LTI limit. Data released by the Central Bank  shows that  PDH lending for the first half of 2017 amounted to €2,770m and that €487m exceeded the limit, or 17.6%, indicating that the limit is being observed, at least for that six month period  (  it  actually applies over a  full year).  Yet the data reveals a marked divergence between FTB’s and other buyers; over 24% of lending to the former was in excess of the 3.5 LTI limit, while for the latter the figure was only 10%.

Clearly the LTI limit is a much bigger issue for FTB’s in an environment of scarce  supply, strong house price inflation and where around half of house sales are going to non-mortgage buyers . As the controls currently stand there is no specific constraint on the amount of  FTB lending in excess of the LTI limit , as long as the overall lending figure is within the 20% exemption.

The Central Bank has responded by amending the LTI exemption. From January the overall 20% limit no longer operates, with  a 20% exemption  limit allocated to FTB lending and 10% to other lending. Had these applied over the first half of the year FTB lending would have been €61bn lower, with no material impact on other lending.

Just over half of PDH lending is currently to FTB’s so the implication is that there is now a 15% overall exemption limit in practice, given a 20% allocation to FTB’s and only 10% to other buyers. The Central Bank argues that FTB lending is less risky than to second or subsequent buyers ( although credit agancies seem to have a different view) , so justifying differential LTV’s and now LTI exemptions, but the changes would appear to mask an effective tightening in overall lending standards. The Bank notes that ‘the refinement is not expected to have a significant impact on the functioning of the market’  but it clearly will limit overall exemptions relative to the  current postion.

The US yield curve and the next recession.

The current US  economic expansion started in July 2009 and is already  much longer than the post-war average, although still  below the 10-year record duration set in the 1990’s, while closing in on the no.2 spot, set at 106 months in the 1960’s. A near term downturn is not inevitable but history suggests is likely at some point over the next few years. Forecasters are  poor at predicting recessions, and so there is interest in other potential signals. Equity markets generally turn down ahead of the real economy but they can and do fall without that precipitating a decline in GDP, so there is a risk of a false signal. The relationship between short term interest rates and long rates  (the yield curve) is another indicator of note, and in the US has proven  remarkably accurate ahead of the last seven downturns. Specifically, a yield curve inversion ( 10 year yields below 2 year yields or as some prefer, 3- month rates) has proven to be an excellent signal of a US recession a year or so ahead.

Why the success as a signal? Longer term  bond yields  carry a risk premium and are therefore generally higher than short rates, and may also be influenced by specific demand/supply factors at different maturities. For example, banks generally buy shorter term bonds, while pension funds seek much longer maturities. Expectations about the path of short term rates over the period are the most important factor, however, which in the US amounts to expectations about the Fed’s monetary policy and inflation. If policy is tightened in response to a booming economy or above target inflation longer term rates tend to rise, albeit by less than the move in short rates (the curve flattens) and may eventually invert if the market believes that  short rates have peaked and will eventually start falling . The inverted yield curve may also help precipitate a downturn because it dampens margins for the banking sector (banks borrow short and lend long)

The US yield curve is not currently  inverted but it has flattened appreciably; the 2-10 year spread has fallen from a peak of 260 basis points in late 2013 to just under 60 now, having started the year at 135.The recent pace of flattening has prompted much market debate  particularly as short rates are still very low by historical standards.

The Fed is  widely forecast to raise short rates again as early as December , and has signalled that it expects to tighten further in 2018, yet  10-year yields have fallen in absolute terms over the past month and are well below the highs in yield recorded earlier in the year.Maturing Treasuries are no longer being fully reinvested and, all things equal, the Fed’s decision to steadily reduce its holdings of bonds might be expected to push yields up. Some argue that issuance is shifting towards  the shorter end of the yield curve, so supporting longer dated paper, which in any case is still in strong demand as a ‘safe’ asset and  such assets are relatively scarce as central banks elsewhere are still buying.

A bigger factor may simply be that the market is convinced, at least for now, that  US inflation will continue to disappoint the Fed and remain below the 2% target, so implying that short rates will not rise to the extent the FOMC expect. The current  core inflation rate is only 1.3% ( the consumption deflator ex food and energy)  and was last (briefly) above 2% in early 2012. Most Fed governors believe that inflation will eventually start to accelerate as wages belatedly respond to the extremely low unemployment rate, but that view is not universally shared. Indeed, the minutes from the most recent FOMC meeting point to growing doubts as to whether sub-target inflation is indeed ‘transitory’.

Yield curve models are currently giving a low probability of recession in 2018 it has to be said ( the New York Fed’s model indicates around 10%) but the yield curve certainly bears watching given the recent trend.

 

Strong new mortgage lending but cash still king in housing market.

The number of new loans for Irish  house purchase topped 8,000 in the the third quarter , according to new data from the BPFI, the highest quarterly total in nine years, with the value figure of €1.8bn also the strongest since late 2008.The average new loan is now €221,000, which is substantially above the €170,000 cycle low recorded in 2013, albeit still well shy of the pre crash peak in excess of €280,000. In fact new lending is  also finally offsetting debt repayment and net mortgage lending  turned positive in the quarter for the first time since early 2010 according to figures from the Central Bank.

So the current housing cycle has been unusual in that it has occurred against a backdrop of  an overall contraction in  credit. Moreover, new lending for house purchase still appears to be accounting for only  50% of housing transactions; the CSO data base shows around 15,500 transactions (filings) in q3, which is almost double the number of mortgage drawdowns. The year to date figures reveal a similar picture, with 20,716 new loans for house purchase set againt over 43,000 in turnover, implying that over 52% of transactions are either cash buyers or have access to a credit source other than Irish mortgage lenders.

The approvals data also suggests that mortgage buyers are being squeezed in the market; approvals  for house purchase exceeded 20,000 in the six months to end- Sept but less than 15,000 were actually drawn down, an unusually low ratio. So potential buyers may be being outbid by investors amid general excess demand. The CSO’s monthly residential price index would certainly indicate that upward pressures are still very much in evidence; annual  house price inflation nationally accelerated to 12.8% in September and 13.2% excluding Dublin. Price inflation in the capital is re-accelerating again after a softer period last winter and the 12.2% annual increase in September brought the total rise from the cycle low to 87%.

Prices nationally are up some 70% since the low in early 2013 and the average new mortgage  has risen 30% in that period, again implying that credit has not been a significant factor in driving the market. Indeed, it would appear that the Central Bank’s mortgage controls have certainly not had a material impact on house prices overall, given the influence of non-credit factors, although they may well have impacted expectations around the announcement period.As we have argued elsewhere  (http://danmclaughlin.ie/blog/qe-is-fuelling-irish-house-prices/) the broader financial backdrop, notably the ECB’s asset purchase programme , has impacted the market by pushing down the rate of return on alternative assets and boosting investor interest in property markets.

Irish Misery Index on rise after all-time low

Irish consumer sentiment, as captured by the KBC/ESRI monthly index, reached a record high early in 2016 before slipping back later that year.It has picked up again in recent months and is now close to the previous peak. Households would therefore seem to feel good about the economy and their own financial situation and an alternative measure, the Misery Index, tells a similar story.

That is simply the sum of the unemployment rate and the inflation rate, two readily available monthly indicators that are likely to have a strong impact on the average household. The index fell to around 6 in 2004, reflecting an unemployment rate of 4.5%, and soared to a high of 18 in 2011 amid a collapse in employment.

The steady fall in unemployment in recent years has been the main driver of the decline in the index, which fell to an all-time low in June of 5.7%, with inflation at -0.4% and unemployment at 6.1%.The latter has fallen further, to 6.0%, but inflation has turned modestly positive so the index is now rising again, albeit still at 6.3%.

The Misery index has probably bottomed in this cycle, however, given the likely trend from here in inflation and unemployment. The latter may find it difficult to fall much further as the recent data implies we are at or near full employment; it has taken five months for the unemployment rate to fall from 6.2% to 6.0%.

Inflation may well see the sharpest change. Falling energy  prices and lower mortgage rates were big factors in dampening the CPI over the past three years but energy costs  have now started to rise again on an annual basis and mortgage costs are now unchanged on a year earlier.  The euro’s appreciation against  Sterling has proved a significant  counterweight over the past year, reducing the price of imported goods, notably food, but that will not be repeated absent another lurch down in the UK exchange rate.

Consequently, we may well have already seem the low of the cycle in the Misery index, although the increase may well be at a modest pace.