ECB rate rise will hurt but not as much as in the past

The first ECB rate rise in over a decade was universally expected later this year and it is now likely to be announced on the 21st July. The most recent data has led to the capitulation of the more dovish Council members, with its combination of record low euro area unemployment, another fresh high in the headline inflation rate , at 7.5%, and a big jump in the core rate, to 3.5%.

The market has been pricing in higher rates for some time although expectations are volatile and at the time of writing longer term rates have fallen from the recent highs, albeit with 1-month euribor still priced at 1.25% by end 2023, or over 1.75% above the current level. For this year, three quarter point increases are fully priced in, taking rates well into positive territory by Christmas.

Higher money market rates will eventually feed through into retail rates but the impact on Irish households may well be less painful than in the past. First, rates are much lower than at the beginning of previous tightening cycles – the average rate on outstanding mortgages is currently 2.45%, including a variable rate average of 2.16%. Second, household debt here has been falling for 14 years and is now down to 98% of household disposable income, against well over 200% at the peak of the Tiger era. Third, in the aggregate households now have far more cash and deposits than debt, with the gap widening to €54bn in the final quarter of 2021.

A fourth factor relates to the mortgage market itself which in the past was largely based on variable (floating) rate debt, meaning a relatively quick pass-through from wholesale rates to most borrowers. In recent years that has changed as around 85% of new loans are fixed, with the majority over three years. Over time, the proportion of outstanding mortgages on variable rates has fallen and is now down to 50%, against over 90% when the ECB last raised rates in 2011.

Irish fixed rates are generally on a shorter term than the EA norm and so over the next few years many will have to revert to a new fixed rate or to a variable and both are likely to be higher, although given the hit to real incomes from inflation (now 7%) a few years respite will be welcome.

Although an ECB rate increase looks inevitable now, the impact on Ireland, at least initially, will also depend on which rates the ECB choose to adjust. Short- term money market rates are currently tied closely to the ECB deposit rate, at -0.5%, and that will move up in order to push up market rates. The refinancing rate is zero and the spread between the two rates has varied historically, from 0.25% to as wide as 1%, so it is not a given that the refinancing rate will also move up in July, although on balance that appears most likely.

When the refinancing rate moves may be open to debate but not the impact here as 30% of outstanding mortgages are on Tracker rates i.e. at a fixed spread over the refinancing rate. That percentage has been falling steadily as mortgages mature (it was still as high as 50% in 2015) and the average rate has been extraordinarily low for some time (1.05%) but if the refinancing rate does rise by 0.75% by year-end that will increase Tracker rates by the same amount.

One final point . Two major mortgage lenders are leaving the market which all things equal will reduce competition for loans, although a number of new niche lenders appear to be picking up market share in terms of new lending. How mortgages are funded is key though, and the remaining banks have a huge pool of excess deposits, paying zero or even negative rates , to call upon, against other lenders who are solely reliant on market rates .Ultimately higher market rates will be passed through but the timing may vary depending on that funding mix; new Irish mortgage rates rose in March, as across the EA, but with a difference in that here new fixed rates were unchanged and the increase was in variable rates.

Irish Housing Market Update

  1. The housing stock per head is still falling

Housing completions in 2021 amounted to 20,433 which is marginally down on the previous year and lower than the prepandemic figure of over 21,000 in 2019. This means that the housing stock is rising by around 1% a year and as such below the growth in population so the housing stock per head is falling, and has been declining since 2008.Planning permissions are running at around an annual pace of 40,000 and although not translating on a consistent basis into actual builds we expect completions to pick up strongly this year, to 25,000 and as such outpace the rise in population.

2.Employment growth is very strong

Housing demand is driven by household income growth , in turn strongly impacted by changes in employment. Ireland is again close to full employment with the vacancy rate at record levels .The Government’s fiscal support during the pandemic helped support the housing market by preventing a fall in household incomes, and employment in professional and other higher income occupations continued to rise.

3.House price growth is in line with fundamental models

There are various approaches to modelling house prices and we prefer a simple fundamental model comprising household income , the housing stock per head and real mortgage rates.The model tracks actual prices fairly well and does not point to a fundamental overvaluation (prices are actually modestly below fair value in the model ) and values should be rising given a combination of weak supply and rising employment and incomes. The predicted rise in 2021 was 6.7% (it is the annual average ) against the 8.3% outcome as per the CSO residential property price index . For 2022 the forecast is 10.0% which given that price inflation ended 2021 at 14.4% implies an end-2022 figure of around 6%, with the deceleration largely due to our expectation of a significant increase in housing supply.

4. Mortgages are still affordable relative to the long term trend.

The average new mortgage for house purchase in 2021 was just under €250,000 which assuming a 25-year term equates to €1150 a month given the average mortgage rate last year. That is actually well below the average monthly rent nationally and on our affordability model amounts to 26% of gross income. The long term average (going back to 1975) is 28.5% so on that basis affordability is by no means stretched, although the issue for many is accessing a mortgage and a property to buy. It is also noteworthy that the average loan to value appears to be falling, meaning higher deposits from buyers, no doubt reflecting the Help to Buy scheme and the scale of ‘forced’ savings during Lockdowns.

5. New Mortgage lending to rise to €13.6bn this year

Gross mortgage lending amounted to €10.5bn last year according to data from BPFI, which was over €2bn up on the previous year and the strongest annual figure since 2008.Switching has picked up but most lending is for house purchase, amounting to €8.6bn, with two-thirds of that going to First Time Buyers. In the coming year we expect the forecast rise in house completions to drive a significant increase in the number of mortgages for house purchase ( to 42,000 from 35,000 last year) which allied to higher house prices yields a figure of €11.4bn for house purchase. Total mortgage lending is projected at €13.6bn.

6. Net lending is positive again but weak

Perhaps the most striking aspect of the current house price boom is that it is not being driven by credit, as on past occasions.This in part reflects the impact on leverage from the Central Bank’s mortgage controls, with the average Loan to Income at 3.3 which is the lowest in the euro area. Institutional buying is also significant but households are repaying debt as mortgages from the previous boom mature. The result is that net mortgage lending last year rose by just €850m, or 1.2%, which is well below the euro average figure of 5.4%. The projected increase in gross lending should help to boost the net figure in 2022 and we expect an end-year increase of 3.5%.

7. Rent rises also unsurprising

Using data from the CSO on private rents actually paid, last year saw a marked change in the market; rents nationally were falling on an annual basis in the first few months of the year before picking up sharply to an 8.4% annual increase by December. Again this is in line with our fundamental model, driven by employment and the housing stock, although our projected rise in house completions does feed through into a slowdown in rental growth in 2022, to 4% by year-end. This may be an underestimate though, as it would appear that the supply of rental properties is being adversely impacted by rent controls

8. Mortgage rates may rise.

85% of new mortgages are on a fixed rate and that trend has been in place for some time now, so impacting the stock of outstanding mortgages and making the market less sensitive than it was to changes in ECB rates. Nonetheless , just over half the existing mortgage debt in Ireland is on a variable rate, with the majority of those loans on a Tracker rate, which moves with the ECB’s refinancing rate.The prospect of an increase in the latter has increased as the ECB now appears inclined to tighten monetary policy this year although any initial moves would be via the deposit rate, which would impact new variable rates and new fixed rates. Nothing is set in stone as yet but it is likely that borrowers will face higher rates for new loans by the autumn or earlier, with Tracker rates moving up in 2023.