Euro rate rise expectations overdone

Just over a year ago the ECB cut its main refinancing rate to zero and its deposit rate to -0.4%, having first shifted the latter into negative territory in June 2014. As a result money market rates have also been negative for some time while longer dated  rates only turn positive at a maturity above 3 years. Yet March saw a change in the market view with regard to the ECB’s monetary policy and the possible timing of an interest rate rise, reflecting  both incoming data and  what were perceived as less dovish comments from Frankfurt.

The  euro composite PMI has  certainly continued to strengthen, reaching a six-year high in March,  and points to 0.6% rise in GDP in the first quarter given the past relationship between the two series, with the prospect of even stronger growth in q2. That, in turn, would point to a significant  upward revison to the current consensus growth  forecast for 2017 of 1.7%. Headline inflation also surprised to the upside, reaching 2% in February,  slighly above the ECB’s target.

The market also reacted to President Draghi’s comments that the ‘risks  of deflation have largely disappeared‘. The Governing Council still expects rates to remain ‘at present or lower levels for an extended period’  but Draghi also said that there was a ‘cursory’ discussion  at the March policy meeting about removing the prospect of a further rate cut while also stating that no Council member favoured any additional long term lending to the banking system . The market responded by giving a much higher probability  of a 0.1% rise in the deposit rate  this year and certainly by mid-2018.

The  ECB later let it be known that it felt the reaction excessive relative to the message it was seeking to deliver and rate rise expectations have been pared back somewhat, with a rise of 0.05% priced in by March 2018. The data has also been less suppotive and indeed worrisome for the ECB. The flash estimate for March inflation was much lower than expected, at 1.5%, and if one excludes food and energy the rate fell back to cycle low of 0.7%. Moreover, the modest uptick in credit growth that had been apparent appears to have stalled, with the annual rise in loans to the private sector easing in February, to 2.3%. These figures  impacted the euro, which is now trading back at $1.065 having spiked to over $1.08. The ECB also puts some store on the 5 yr 5 yr inflation swap as a measure of inflation expectations ( albeit less so now than in the past) and that has fallen back below 1.6%.

Some claim the March inflation data owes a lot to the timing of Easter ( in March last year ) and that there will be a seasonal rebound in April, including the core measures.  Unemployment in the euro area is also falling steadily, which might be expected to push up wage inflation ( although the latter has continually disappointed  forecasters) and that view is reflected in ECB projections, which envisage core inflation picking up to average 1.8% in 2019.

On market rates themselves, the level of excess liquidity ensures that short rates do not stray too far from the deposit rate , which is -0.4%. That excess, which tops €1,500bn, is the amount the ECB is pumping into the banking system, via QE and the TLTRO, over and above the liquidity  banks need to meet normal requirements. The Governing Council hopes this will be used to boost bank lending but so far the impact is limited, and one wonders what the ECB would do if credit growth slows in a material way. That issue may not arise but unless core inflation picks up appreciably any rate rise speculation is premature.


Odd Timing for Proposed Irish Mortage Restrictions

Interest rates are extraordinarily low in many parts of the world; the ECB refinancing rate is 0.05%, in the US the equivalent is less than 0.25% and in the UK the Bank rate is 0.5%.Rates are expected to rise next year in both the UK and the US but the respective central banks have made it clear that any increases are likely to be moderate and that  the cost of borrowing may well settle at levels below previous cyclical highs. In the euro area the economic  outlook is bleaker and most observers expect rates to remain at current levels for a number of years. This low-rate environment carries potential risks for asset bubbles and excessive credit growth so central banks have embraced the idea of macro-prudential tools i.e. measures that can be implemented to protect against systemic financial instability. The housing market is often seen as a specific stability risk and a number of countries have introduced restrictions on mortgage lending, the latest being the UK, where only 15% of new mortgages can be above a Loan to Income (LTI) ratio of 4.5.

The Irish Central bank has now entered  macro-prudential territory with proposals on mortgage lending designed to ‘increase the resilience of the banking and household sectors to financial shocks’ .Like the Bank of England there is a restriction relating to LTI, but in the Irish case the limit is lower , at 3,5, although 20% of lending can be above that limit. In addition, the Bank is also proposing restrictions in terms of loan to value (LTV ) with only 15% of lending allowed above an LTV of 80%. For Buy -to Let loans the LTV limit is 70% with only 10% of lending above that. The LTI restrictions only apply to principal dwelling homes (PDH).

The Bank refers to international evidence supporting the view that LTI restrictions can slow mortgage lending growth and ‘reduce the potential for a housing bubble to emerge‘ although the impact on house prices is less clear, with the Bank of England claiming that there is ‘some evidence of a modest and lagged effect on house price growth’. The latter conclusion is not surprising as credit is only one variable in most house price models, with income, interest rate, the user cost of housing and price expectations also playing important roles. The Central Bank also notes that LTV restrictions are more important after a crash, in limiting losses for the lender.

The proposals have generated debate, of course, with some welcoming the move as important in dampening house price inflation (despite the caveat noted above) while other have argued it will hit  the First Time buyer (FTB) particularly hard and dampen housing supply.Indeed, the LTV limit would appear to be binding now, with 44% of new PDH lending  last year above 80%, while only 7% of lending was above 4.5 LTI, with 77% at 3.5 or below.

Another issue is the timing of the proposals. House prices in Dublin have certainly risen sharply of late and are now over 40% above the cycle low but outside the capital prices have recovered by just 9% and most observers, including the Central Bank and the ESRI, still conclude that prices are not excessive relative to fundamentals such as income or rents. A greater puzzle on timing relates to the credit cycle, given that the restrictions are designed to directly impact lending.The stock of outstanding mortgage debt in Ireland has been falling now for five years and the latest figure, for September, showed a 3.1% annual decline. New mortgage lending for house purchase is picking up but amounted to  just €1.3bn in the first half of 2014 and is still being swamped by redemptions and early repayments. Ireland is therefore hardly swimming in new mortgage lending so restrictions at this time seems premature, particularly as the secondary aim of the moves is to ‘dampen pro-cyclical dynamics between property lending and housing prices’ . That might suggest that restrictions would be better served if actually adjusted for the cycle, with  the LTI limit  reduced if credit growth is deemed too rapid and  the LTV limit reduced if house prices are deemed in excess of fundamentals.

The proposals may indeed dampen  future housing cycles but also have broader societal implications. The Government  was not consulted  and is now reported to be considering some form of mortgage insurance scheme to help FTBs secure a higher LTV.The Governor of the Central Bank in a recent speech also  appeared to be more comfortable  than indicated in the proposal document with the idea of  FTB insurance although with the caveat that who provides the insurance is important. Insurance protects the lender , not the borrower of course, and has to be paid for.A broader conclusion from the Governor’s speech may be that  the proposals will see further modification before implementation, or a longer lead-in time. As it stands the restrictions do have significant implications for  young Irish households, with a longer period of saving in store and therefore a later age for home ownership, at least for some.