QE is fuelling Irish House Prices

Irish residential property prices have risen 60% since the lows of early 2013 but  this cycle is investor rather than credit driven. Gross mortgage lending for house purchase has picked but the average new loan has risen by just 28% over the past four years, implying a fall the average loan to value ratio, while data on transactions (recently revised up by the CSO) indicates that mortgage loans  still appear to be accounting for less than half of turnover in the market. New lending is also now constrained by the Central Bank’s mortgage controls.Moreover, net mortgage lending ( i.e new lending minus repayments) has been falling now for over seven years, although there are recent signs that it may finally be bottoming out.

Nothing here then to indicate that credit is playing a strong role in driving prices and it is curious that little attention has been paid to the impact of the ECB’s monetary policy  on the housing market, and, more specifically, its  non-standard measures including the asset purchase programme. The latter, QE, is designed to boost bond prices and hence lower yields so that ‘ investors may choose to take the funds they receive in exchange for assets sold to the ECB and invest them in other assets. By increasing demand for assets more broadly, this mechanism … pushes prices up and yields down, even for assets that are not directly targeted by the APP’.

QE is generally perceived as having a significant impact on equity markets and it would be odd if it did not therefore impact other  asset markets, including property, and we  can readily  see this at play in the Irish data on transactions. In 2011, investors (here defined as Buy to Let individuals  plus non-household buyers) accounted for 16% of residential transactions rising to 24% by 2012 and averaging a third of the market or more since 2014.

The yield on ‘risk-free’ assets , such as Government bonds, plays a big role in investment decisions and so the plunge in Irish Bond yields has been  a very significant backdrop for the Irish residential and indeed commercial property market : 10-year Irish yields peaked at double digit rates in mid 2011 but really started to fall sharply following Draghi’s ‘whatever it takes’ speech in 2012, and fell below 1% , where they still reside, following the commencement of QE in early 2015.

In contrast, the gross yield on residential property ( average rent/ house price) has not declined significantly in our rental model, and is still at 4.8%, having peaked at 5.4% in 2013. The rental yield fell to  a low of 2.75% during the last cycle, and is still well above the post EMU average (4.25%) and of course extraordinarily high relative to the ‘risk free’ rate available on Irish bonds, let alone Bunds.

The scale of investor interest in Irish property is therefore not surprising given the yield on offer and  is unlikely to disappear any time soon. Higher bond yields would make a difference, no doubt, and in that context the future of QE plays a part; the ECB will soon decide whether to scale back its asset purchases or indeed cease any additional buying. Yet it is likely to reinvest the proceeds of maturing bonds for a while at least, therefore maintaining the stock of QE, so absent an inflation shock bond yields may well stay low by historical standards. If so investor interest in Irish property will continue to be a big driver of the market.

Eligible Irish bonds a constraint on extending QE

The ECB has flagged the possibility of adjusting its asset purchase programme (QE) to  boost economic activity and move inflation closer to target. At the moment the Bank is buying around €60bn of assets a month, with over €50bn in the shape of Government bonds, with the intention of continuing until at least September 2016. One practical concern regarding extending that timeframe  is the supply of eligible bonds and that may well become more of an issue in the Irish market as we move through 2016.

The nominal value of Irish Government bonds  currently outstanding is €125bn, with some €95bn falling within the maturity range eligible for QE (over 2 years and under 30 years). Bonds yielding below -0.2% are also excluded under the current criteria, which affects a number of countries, notably Germany, but not Ireland. The ECB can buy up to 33% of bonds issued, so that implies an Irish figure of  €31bn.

QE started in March and purchases in the Irish market have averaged €0.8bn a month, bringing the total to €6bn at end-October. Plenty of scope left, therefore, except that the ECB and the Irish Central Bank  already hold Irish bonds, and that figure is included in the QE calculation. The Central Bank  acquired €25bn of bonds as part of the Promissory note deal, with €7bn  maturing within 30 years. The ECB’s holdings arose from the Securities Market Program , which operated for a time in 2010, and amounted to €9.7bn at the end of last year. We do not know the current position or how many will mature over the next two years but from the average maturity (4.5 years) it would seem reasonable to assume that  €7bn would redeem after 2017 and hence fall within QE eligibility.

On that basis the ECB and the Irish Central Bank may own an additional €14bn of Irish eligible bonds, bringing the total to €20bn  when adding the QE purchase to date. Absent any other changes that would mean that the ECB could buy an additional €11bn, which at the current pace of purchase implies a maximum of 14 months, taking us to the end of December 2016 or just three months beyond the current timeframe.

On the face of it, then, the scope for extending Irish QE is very limited, although two factors are likely to give the ECB some leeway, albeit not a great amount. The first is additional supply from the NTMA, with perhaps  €10bn issued in 2016, which would boost the eligible bond total by that amount if over 2 years in maturity. That would allow €3.3bn in additional QE , an extension of four months.  In addition , the Central Bank is required to sell at least €0.5bn of its bond holding next year and any sales would leave greater room for ECB buying of bonds held by the market. On that basis Dame Street may well sell far more than the minimum.

Falling Prices versus Deflation

Consumer prices in Ireland fell by 0.3% in the year to December, providing a welcome boost to the real income of Irish households. Prices also fell across the euro area, declining by an average 0.2%  Good news then, one might think, so consumers may well be puzzled by the reaction of policy makers, with the ECB announcing its intention to take further action in order to raise prices and boost the  euro  inflation rate  towards 2% per annum, citing the risk of deflation as the catalyst for the move. Why are falling prices deemed a bad thing when central banks have spent most of the last fifty years worrying about the problems caused by rising prices?

Not everyone is convinced that deflation currently exists in Europe because the concept involves the notion of a persistent fall in prices rather than a short term period of negative inflation. This in turn depends on what is causing prices to fall – is it in response to a supply shock such as a rise in oil production (which some economists have termed ‘good deflation’) or as a consequence of falling demand (‘bad deflation’.) Looking at the Irish CPI it is clear that a key factor is the sharp decline in global commodity  prices , which started in earnest over the summer months and has resulted in declining food prices ( down 2.7% in the year to December) and energy costs ( down 5.5%). The latter has further to fall and largely for that reason most forecasts  envisage the annual inflation rate staying negative in Ireland and across the euro area for at least the first half of 2015.

If one excludes energy and unprocessed food Irish prices rose, albeit by a modest 0.5%, and this points to the case  against the prospect of deflation – energy prices will not fall for ever and so the deflationary impact on the CPI will eventually fade. Goods prices account for less than  half of the Irish CPI (45%) and the price of services is still rising ( up 1.7% or 2.8% excluding mortgages) so a sustained fall in  the CPI would probably in turn require a prolonged and heavy  fall in wages. Ireland has seen a  modest fall in wages on one measure (the micro data at industry level) but not on another (the aggregate wage figure used in the national accounts)  while wage growth is positive on average across the euro area.

The performance of  euro equity markets would also suggest that deflation is not a base case,  and the ECB concurs, although stressing that the risks have risen. Modern experience of deflation is limited to Japan but prices also fell steadily during the Great Depression in the US and elsewhere, which has contributed to the association of falling prices with very negative developments in the real economy. The argument partly focuses on expectations , with households and firms postponing consumption and investment in anticipation of lower prices  next year. Deflation will also  affect real interest rates as nominal rates for most borrowers are bounded at or close to zero, implying real rates will rise if the price level falls. This would increase savings and reduce consumption and investment.Similarly, if nominal prices and incomes fall the real burden of household and government debt rises, a particular concern given the current scale of outstanding debt.

The expectations element in deflation has made central banks, including the ECB, very keen to monitor the private sector’s view on future prices. That can be hard to gauge (surveys tend to be strongly influenced by the recent trend) which makes market-based measures ( inflation swaps or derived from nominal versus real bond  yields)  popular as they can be monitored in real time. On that basis the US market is expecting inflation  to average around 1.5% a year for rhe next decade while the ECB’s favourite measure suggests euro investors expect inflation in 5-years time to also average around 1.5% over the following 5 years.

Evidence, then, that inflation is expected to be low and certainly below  the 2% level many central banks view as optimal, but not that there is a widespread belief that inflation will stay negative for a long time. This low inflation outlook is not a scenario which implies strong growth in nominal wages but certainly one in which short periods of falling prices is a positive rather than a negative.