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Interest rates are heading up – here are five things you need to know

Smart Money: From mortgages, to the markets and the State finances, change is coming

Interest rate are heading higher. And as there are few more fundamental issues than the price of money, this has big implications for our personal finances and for the State.

Longer term rates on money markets are already rising and so are short-term central bank rates in the UK and, soon, the US. This has set off a big debate among economists and central bankers themselves – some feel higher rates risk choking off recovery, while others argue that the monetary authorities are already behind the curve in responding to inflation, which risks becoming embedded.

As this story plays out, here are the key things to watch.

1. How fast does the European Central Bank move?

The Bank of England has increased its key rate twice already and the US Fed has signalled up to five small increases this year. Having originally indicated that its rates were unlikely to rise this year, ECB president Christine Lagarde pivoted last week and refused to rule out an increase. The speculation now is that the ECB might increase the deposit rate it pays banks for overnight money – now minus 0.5 per cent – to around zero per cent by the end of the year, possibly in two steps. As of now this is not seen likely to happen until the last quarter of the year.

With economies just emerging from the pandemic shock, there is a big debate on what central banks are doing, particularly as part of the current high inflation rate is likely to be transitory. Central Bank rate rises take time to have an impact, but banks are also trying to send a signal to persuade businesses and consumers that a cycle of runaway inflation is not getting underway.

2. What will the ECB move mean?

An increase in the ECB’s deposit rate will not knock on automatically to tracker mortgage rates, which are tied to its main refinancing rate, currently at zero per cent. It might rise in 2023. However an increase in any of the ECB rates would mean the end of the slow downward trend in rates charged to borrowers , particularly fixed rate offers.

It will be interesting to see how banks react. Driven by some new players in the market, the average mortgage rates for news loans has continued to edge downwards, with some attractive fixed rate offers now below 2 per cent. But the average rate for a new mortgage loan of 2.69 per cent is still the the highest in the euro zone and over double the 1.29 per cent average.

According to Daragh Cassidy of Bonkers.ie, " given the huge disparity between rates in Ireland and the rest of the euro zone at the moment, there is potentially room for Irish lenders to absorb a small increase" – in other words not to pass the initial ECB moves on to borrowers. Competition may drive this. But sooner or later an upward trend in rates will be reflected in borrowing costs.

A key issue will also be what banks do with savings rates. In times of low interest rates, core profit margins at banks – the difference between lending and deposit rates – tend to be compressed. So banks will try to widen this as rates rise – savers may continue to suffer, given that banks are not short of cash to lend out and do not need to fight for deposits.

3. And what does it mean for State borrowing costs?

The era of “ free money” – of the State borrowing at zero interest rates or close to it – is over. Of course the money was not entirely “ free” because borrowings have to be refinanced at some stage. But low interest rates before and particularly during the pandemic have allowed the State’s debt-raising agency, the NTMA, to reduce the average interest rate on all borrowings to 1.5 per cent. During the pandemic the NTMA borrowed €42.5 billion at an average interest rate of just 0.2 per cent. Back last January it managed to raise 10-year borrowings at minus 0.26 per cent.

Now things are changing quickly. The interest rate on the Republic’s 10-year bonds is now approaching 0.8 per cent, still exceptionally low, but a significant increase from 0.16 per cent at the start of the year. If inflation remains high and fears of the extent of ECB increases over the next few years grow, then bond interest rates could head significantly higher. A key marker would be 1.5 per cent, which is the average interest rate of all the outstanding Irish national debt.

If, for example, borrowing rates for the State were one percentage point higher this year than last, then the interest cost on our targeted €14 billion of new borrowings would be €140 million higher per annum. The ECB is also running down its purchases of Government bonds – the special assistance programme for the pandemic. These purchases had been effectively underwriting borrowing across the euro zone. When they are gone, it is just hard to know where these borrowing rates will settle. With a large cash pile and relatively low refinancing needs, it will be some time before higher rates show up in any significant rise in the cost of our national debt.

4. Will there be market turmoil?

It is hard to see this all going smoothly. Already we have seen share prices under pressure, particularly of more speculative stock where investors are betting on future profit and capital growth, rather than getting dividends from current ones. The current value of these potential future earnings is lower as interest rates rise. Bond markets are also wobbling. A key issue to watch will be the performance of higher debt euro zone countries, notably Italy and Greece, where the gap with German bond rates has widened in recent days. Irish rates remain around those of France and a vital goal for the Government will be maintaining Ireland’s position in the ranking of euro zone borrowers.

Meanwhile, there are also potential knocks on from US rate rises to emerging markets. As central banks gradually tighten policy, the wave of investor cash looking for a home which was unleashed by rock bottom borrowing rates will dwindle, with unpredictable consequences across all asset market. Bond interest rates are a foundation stone of financial markets and investments and the fundamental changes now underway will have a far-reaching impact.

5. How far will interest rates rise in this cycle?

The top of each successive interest rate cycle has become lower and lower since the 1980s, a trend attributed to generally slow economic growth and ageing populations, who need less incentive to save. Even though interest rates are rising now, it is from a very low level – and a key goal of central banks is to give themselves some headroom to reduce rates again when the next crisis hits, or the cycle turns down. ECB base rates started at 3 per cent when the bank was founded in 1999, rose to 4.25 per cent in 2000, but since March 2009 have never exceeded 1.5 per cent. The trend in inflation will be the key factor to determine where they go in this cycle – but it is a long way up from zero.

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