Ground impact: weighing up the interest rate environment

We have got used to interest rates being low, but the extent to which financial markets believe they are set to stay low has not yet hit home fully with borrowers. Consider the following. Right now the price at which interest rate futures are trading suggests that the ECB will not increase base interest rates until 2018 – at the earliest.

It is also pricing in the possibility that ECB rates could be cut in to negative territory, as has happened in Sweden and Switzerland.

Now markets are often wrong – and the hardest thing of all to predict is the turning point in a trend. The dose of monetary expansion now taking place may finally start to stir inflation some time next year, bringing forward the first ECB increase.

Yet two things are clear. First, the next move by the European Central Bank will be to ease policy further and, while this may not involve actual negative interest rates, there is no thought of any rise in base rates on the horizon, even by the monetary hardliners on the ECB board from countries such as Germany and the Netherlands. Second, the expectations for how far interest rates might rise, once they do start increasing, are changing fundamentally.

This point was underlined by the US Federal Reserve Board in its statement during the week. Most of the attention in the Fed statement was on its clear indication that it would consider raising rates at its meeting in December. Remember though that rates are effectively at zero and the pace of increase will be slow.

The Fed statement made it crystal clear that interest rates will remain at historically low levels for the foreseeable future.

The world has been obsessing about when US rates would rise, but the message from Janet Yellen and the Fed Council was that, even if they do, monetary policy will remain easy for as long as it takes. And that looks like being a long time. Welcome to the era of super-low interest rates.

In the back of people’s minds have been historical trends which suggested that borrowing rates could only rise from where they are and could do so significantly. However, very low rates now seem the new norm in an era of low growth and almost absent inflation.

Here is what this will mean for the key players in the economy.

1: The State

The State still has to borrow significant amounts to bridge the gap between spending and revenue and refinance maturing debt. This year it has closed off its books having raised some €13 billion – out of a target of between €12 billion and €15 billion.

With the general election now planned for early 2016 and any uncertainty about the shape of the new administration likely to put a temporary halt to fundraising during a campaign, the NTMA might wish that it had kept open the option of raising some more funds this month. However, with long-term market rates edging down further this week, the outlook remains good.

At the moment, the cost of raising 10-year borrowings would be not far above 1 per cent, with lower or even negative rates on shorter-term borrowing. The longer these continue, the greater the benefits that can be locked in to reduce the burden of financing our national debt each year.

At the moment this extends the “sweet spot” in which the Irish economy has found itself, says Dermot O’Leary, chief economist at Goodbody stockbrokers. The combination of fast growth and very low interest rates is allowing Ireland to reduce its debt ratio and cut borrowing, starting to work off the damaging debt legacy of the bust and the bank bail-out.

The risk, of course, is that the low growth/low inflation mix stalking the continental European economies starts to damage economic growth here. For the moment, though, growth here remains strong.

2: Borrowers

The era of super-low interest rates, if sustained, has fundamental implications for Irish borrowers.

Over recent years, there have been warnings to mortgage borrowers in particular not to get too used to current interest rates. They can only rise in future was the message.

However, if the market forecasts are right and the ECB keeps base rates low, mortgage rates should not rise. We have seen a general lowering of rates so far this year, as the Government put pressure on the banks. Competition and political pressure could mean standard variable mortgage rates edging a bit lower in the months ahead.

In any case, until the ECB starts moving interest rates higher, there is no reason why standard variable rates will rise.

Rising bond market interest rates – which would typically come in advance of an ECB move – could push up the cost of longer-term fixed rate mortgage contracts.

However, with the ECB set to extend its programme of bond-buying in December, this should keep bond rates low, too, barring some kind of market upheaval driven by events elsewhere in Europe, or in emerging markets.

3: Savers and Investors

It is not a good time to be looking for a return on your money – or at least a guaranteed one. There is little value to be had from investing in bond markets, or putting your money in the bank.

If you search around, you can still get an interest rate return of about 1 per cent if you are prepared to tie up your money for a year or more, although in most cases rates are 0.8 per cent or less.

Certain savings products, such as An Post savings certificates, offer returns of a bit over 1 per cent a year for longer-term savings and the National Solidarity Bond will return 2 per cent plus per annum, but requires a 10-year commitment.With no general inflation, the real value of savings is not being eroded, although those depending on interest rates to top up their income are not doing well.

Rock-bottom interest rates are also bad news for those buying an annuity as they retire, as they push up the cost of this kind of product significantly. In fact, low interest rates are bad for pension funds in general, as they push up liabilities and push down the return on assets, and are thus likely to keep up pressure on the beleaguered defined benefit sector.

In this environment, everyone is searching for “ yield” supporting equity markets in particular.

Analyst opinion is split on how sustainable this is or whether low international growth will eventually be reflected in share prices.

In short, there is no easy option for investors. Looking for more return means taking more risk.

4: Banks and the financial sector

Banks are generally seen to benefit when interest rates rise, as it gives them more scope to push out the margin between the cost of funding and the return.

However, Irish banks are currently operating on decent margins – this was part of the recent controversy over mortgage costs, where relatively high standard variable mortgage rates are in place, in part, to compensate for rock-bottom tracker mortgage rates.

Low interest rates will keep the cost of funding low for Ireland’s banks, according to John Cronin, head of financials research with Investec, which is a significant advantage for them.

When ECB rates do start to rise, rates to borrowers will reflect this, but it could be a challenge for banks to increase their profit margins in this context, Cronin says. In any event, any ECB rise is now seen likely to be a long way off.

The challenge for banks is to push up profits in the current environment.

Meanwhile, he warns that low interest rates will keep up the pressure on insurance companies because its hits the return on their investment portfolio. In turn, this will be a factor keeping upward pressure on insurance premiums.