ECB rate rise next year not a done deal

In June, the ECB announced it was likely to end its net asset purchase  programme in December and that it expected to keep interest rates at their present level ‘at least through the summer of 2019‘ , albeit with a caveat relating to inflation developments remaining in line with the Banks expectation of a steady convergence to target. Some confusion ensued as to when the summer actually ends but the ECB has since indicated it is happy enough with market expectations of a rate rise at the September or October meetings next year.

Any change is more likely to initially  involve the  ECB’s Deposit rate rather than the Refinancing rate, and the latter is more significant for existing Irish mortgage holders as Tracker rates account for over 40% of the stock of mortgage loans.However,  it would then  only be a short period of time before a rise in the refinancing rate occurred if the ECB was  set to embark on monetary tightening.

Why has the Governing Council decided to signal a probable rate rise? In part because the EA economy performed strongly in the latter part of 2017 and although growth moderated in the first half of this year, to 0.4% per quarter, that is still above what the Bank considers to be potential, which has resulted in further falls in the unemployment rate. The ECB is also more confident that wages are finally responding to the tighter labour market, and as a result expects underlying inflation to pick up steadily , with the ex food and energy measure forecast to average 1.8% in 2020 from 1.1% this year. As such , the Council is more confident of a ‘sustained convergence’ in headline inflation to target.

In fact headline inflation has been above target for the past four months, oscillating between 2% and 2.1%, boosted by higher energy prices. Yet that is also squeezing household incomes ( wage growth was 1.9% in q2) and core inflation ( which excludes food , energy, alcohol and tobacco ) has remained stubbornly at 1.1% or below in recent months, slipping back to 0.9% in September.

The  economic outlook also looks less robust than it did. The ECB maintains that the risks to EA growth are balanced but at their September meeting  it was noted that a case could be made that the risks had tilted to the downside. Since then , the global outlook certainly seems to have deteriorated amid a backdrop of falling equity markets, rising trade tensions, weaker growth in China, a rising dollar, Brexit uncertainties and  Italy’s apparent willingness to breach euro fiscal rules.

Indeed, some of the hard data in the EA has been noticeably weaker over the summer months and the PMIs have also softened, with the latest reading for the EA as a whole dropping to a 2-year low of 52.7 in October, That is consistent with GDP growth of only 0.2% a quarter and it will be interesting to see whether the ECB reiterates its balanced risk view at the upcoming meeting.

It may be that the current weakness in sentiment and activity proves temporary but what may also concern the ECB is that more forward looking indicators also signal weakness ahead. The major European equity indices are all heavily in the red year to date while monetary indicators are not reassuring; M3  growth has slowed to 3.5% while the growth rate of lending to the private sector has remained becalmed at 3.4% in recent months, with mortgage lending slowing a little to 3.2%.

It is unlikely that the ECB will do a volte- face on its forward guidance at this juncture but the risks to their view on inflation have risen and it is not a done deal that rates will rise in 2019.

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.