ECB hike: Speed of interest rate rise could catch mortgage-holders unexpectedly

How much higher will interest rates go? That is the big question after the latest 0.75 percentage point ECB interest rate increase. This one was so well flagged that nobody was surprised, though it will prompt a rise in tracker mortgage rates and in the deals on offer to new borrowers. Another increase is on the cards for December, and for now the markets are pencilling in more for 2023. European Central Bank (ECB) interest rates were never going to stay at zero forever — but the speed at which they are rising may catch borrowers unexpectedly. And at a time when higher energy costs are already biting hard, this will put some households in further difficulty.

Rising interest rates are already starting to have an impact on the mortgage market — and the uncertainty about how high they will go could lead to a “confidence dip”, according to Brokers Ireland, the group that represents mortgage brokers, who warned that this could affect demand and housing supply.

[ Explainer: What will the ECB rate hike mean for your mortgage? ]

The ECB, like other central banks, is now in the danger zone, committed to pushing up interest rates to contain an inflation rate of almost 10 per cent, just as the euro zone economy is slowing. The latest purchasing managers’ index figures, published earlier this week, showed weakness across the manufacturing sector, with activity falling faster than expected. Meanwhile, senior politicians are starting to mumble, albeit in coded language, about the wisdom of pushing up interest rates against this backdrop. By the end of this year, or early 2023, this could turn into a much more public battle, depending on how the economic chips fall.

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For the economy, it will be a bit like a recast of an old line “the beatings will continue until inflation improves”, according to Gerard Brady, chief economist at Ibec. “Central bankers have emphasised that they see their role as getting inflation down first and worrying about the impact on growth and employment second. They are concerned expectations of inflation get out of control and people begin to act as if it will continue to rise, until it becomes a self-perpetuating cycle — so they are front loading the pain to head that off.”

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This front-loading is starting to look expensive for mortgage holders. Those immediately hit are the 200,000-plus tracker mortgage holders, who are mainly buyers from the Celtic Tiger era, some still with significant outstanding loans. Depending on loan size and their outstanding term, their repayments will, after the latest rise, be some €180-€190 a month ahead of what they were before this round of rate rises started. By next year this could easily rise to €275 or €300 higher per month. This will include some borrowers who were deep in negative equity for many years — and some who went into the mortgage arrears process and have been identified as being vulnerable again now as monthly costs rise. Rachel McGovern of Brokers Ireland warned that those carrying legacy debt and just about meeting their revised commitments could again be in difficulty.

Trackers were for so many years the golden ticket for Irish mortgage holders, but some tracker holders are now switching to fixed rates, worried about what is to come. As fixed rate offers are now starting to rise — and there is typically a process of two months or more to switch — those who want the security of a fixed rate for the next few years at least need to move quickly. The “right” thing to do depends on the type of tracker loan — particularly the spread over ECB rates — and the circumstances of the borrower and their plans. Professional advice is essential.

[ The Irish Times view on ECB interest rates: striking a balance ]

Standard variable mortgage rates — which have offered poor value in recent years in the upside-down Irish mortgage market, are also likely to start increasing shortly. They have not been popular with new borrowers and the average outstanding balance of the 150,000 or so variable rate mortgages is around €80,000 — so they are typically held by older mortgage holders who are coming to the end of their loan period. The financial incentive for this group to switch is not so high, though many would be advised to consider their options. The window was closing as fixed rate offers are starting to come off the table, Brokers Ireland warned and those on variable rates need to reassess their position without delay.

The real competitive action is in the fixed rate offers for new borrowers, typically for three to five years. Longer term offers have also been a feature of the market, though Finance Ireland’s recent decision to suspend its 10-year and longer fixed rate product is a sign of the pressures on smaller lenders, who typically depend more on the wholesale market to fund their loans, as opposed to the big lenders who also have large customer deposits.

AIB has already increased its fixed rate offers by around half a point and the scale of the latest increase means a repricing of this market will happen quickly, with offers below 2.5 per cent disappearing off the table. This, together with the requirement for banks to stress test mortgages to ensure borrowers can afford yet higher rates, is going to shut some people out of the market. The move by the Central Bank to allow borrowers to take on loans of up to four-times their income will act in the opposite direction, of course.

More interest rate rises are “in the pipeline”, according to ECB president Christine Lagarde, though she would not speculate how many. The anticipated path of rate increases would see another half point increase in ECB rates in December — bringing the key deposit rate to 2 per cent — and further increases next year, taking the rate to 2.5 per cent by spring and perhaps even higher towards 3 per cent later in the year.

While another increase in December looks very likely, what happens after that is uncertain. Markets revised down their expectations a bit after the ECB meeting and now reckon the ECB deposit rate — 1.5 per cent after the most recent rise — could top out at 2.75 per cent. Previous expectations had gone as high as 3.25 per cent. As this plays out it could lead to fresh divisions opening up again on the ECB board between those who want a more gradual approach and the so-called monetary hawks — now in the ascendant — who believe a rapid pace of increase is essential to clamp down on inflation.

[ Explainer: What will the ECB rate hike mean for your mortgage? ]

A vital indicator for the ECB is people’s expectations of inflation and a recent survey showed they now expect the inflation rate to be 5 per cent next year and 4.7 per cent in three years time. For the ECB, this change in what are called inflationary expectations are deeply worrying. This is the argument to keep pushing interest rates higher.

On the flip side, it is clear that euro zone growth is slowing rapidly and this will slow demand and should bear down on inflation. Also, the driver of inflation this time is not — generally — overheated demand, but supply side factors including higher energy prices and other fallouts from the war in Ukraine and the post-Covid problems which have hit global supply chains. Higher interest rates cannot fix these issues, though they can cut demand to bring it back closer to available supply. But at what cost?

French president Emmanuel Macron referred pointedly in a recent interview to the risk of higher interest rates “shattering demand”, and newly elected Italian prime minister Giorgia Meloni warned of the ECB making what some people thought were ”risky choices”. Italy would be one of the countries seen to be at risk as the ECB increases interest rates and withdraws support from national bond markets. Whether what the Italians call “lo spread”, the gap between German and Italian rates, starts to rise further as a consequence, or if there is destabilising speculation, remains to be seen. The ECB has a special programme in place to try to guard against this happening, though it has not been tested under fire from the markets as of yet.

The ECB may well pitch the economy into a recession with such aggressive tightening into weaker growth

The financial upheaval in the UK, while triggered by UK-specific factors, has raised concerns that as the ECB hikes rates — and withdraws support for government borrowing by starting to run down the massive holding of bonds it has built up — the euro zone, too, could face financial risks. The explosion of problems in a corner of the UK pensions market illustrates the risks of unintended consequences. And the ECB, while it will not pump new support into bond markets, has said that it has not yet discussed “quantitative tightening” — the sustained running down of its bond portfolio. This led to some weakness in the euro after the ECB meeting, despite the rate rise.

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Hints from the less hawkish side of the ECB governing council indicate that they feel an increase in rates into next year should not be taken for granted. French central bank governor Francois Villeroy de Galhaus said in an interview that the ECB, having increased rates to around 2 per cent by the end of the year, might then wait and see what the data and economic trends show before deciding what to do next. Moving too fast might raise risks of a “vicious loop” in financial markets, he warned.

Markets are full of debate internationally about where rates will top out. The Canadian central bank said it was near the top of its interest rate cycle after another increase this week, but like the US Federal Reserve Board, its rates are well ahead of the ECB. A faction on the ECB board will want to press on next year, increasing interest rates well above what might be judged a neutral level — which neither stimulates nor takes demand out of the economy — generally seen to be around 2 per cent, or perhaps slightly higher.

Even this concept of a neutral rate is somewhat controversial, given the huge time lags with which monetary policy operates. And this is the centre of the ECB’s problem. Is it risking imposing huge costs on the euro zone economy at a time when recession seems likely?

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“There’s a good chance Italy and Germany are already contracting,” according to Megan Greene, senior fellow at the Havard Kennedy business school. “The ECB may well pitch the economy into a recession with such aggressive tightening into weaker growth. But they — like the Fed — have been clear they would rather that outcome than risk waiting too late, seeing inflation rise even further and having to hike rates even more to bring inflation down. The latter scenario could cause a much bigger recession and more pain for households and businesses.”

The ECB decision could be represented as walking a tightrope. But given the extraordinary economic situation and the huge surge in inflation, a real question is whether there is a “right answer”. There may simply be no middle road between bearing down on inflation and not adding to the significant economic slowdown which Europe is facing into. And what does pressing ahead as economic growth collapses mean for the reputation of the central bank?

[ Analysis: ECB more hawkish on rates as inflation outlook deteriorates ]

In the wider economy, higher interest rates change everything. “The past decade has seen the lowest consistent period of interest rates at any time since the emergence of the modern industrial economy in the 18th century,” according to Brady of Ibec. “The monetary reset under way is already changing capital allocation in the global economy, with material impacts on businesses. In Irish business, it’s a particular challenge for business founders with long ‘runways’ to sustained profitability and for finding funding for developing homes or commercial real estate, where returns might be comparable to ‘safe’ assets like treasuries.”

In simple terms, investors now face safer, risk-free choices than investing in a business start-up, or a housing or apartment development. And higher interest rates also work on the other side of the equation, hitting demand for these assets and thus further affecting viability. The era of super-low interest rates appears to have finally drawn to a close and the long tail of inflation means it will not be returning any time soon.

Welcome to the new world, even if we are not sure yet exactly what it will look like.