There is little doubt now that interest rates are heading higher. Increases are already underway in the UK and US and markets expect the ECB to move before the end of the year. The only thing which might stay the ECB’s hand is if the euro zone economy collapses into recession. For now, with inflation rates heading sharply higher, all the signs are interest rates are rising too. But a vital question for borrowers is how high they will go.
1. Great expectations
Market expectations of the extent of likely interest rate rises have jumped sharply in recent weeks. Having started the year at around 0.3 per cent, the State’s 10-year interest rates – a key indicator of the price of borrowing – are now close to 1.4 per cent. Government bond interest rates have risen internationally, though the spread or gap between Irish interest rates and those in Germany has widened a bit – and Italian and Greek rates have risen much more sharply again.
A crucial driver of this comes from ECB signals that it will quickly wind down its programme of buying government bonds. This had provided a ready buyer if needed for those investing in euro zone government bonds – a kind of insurance policy meaning they could sell their holdings on if needed. Now this will end. For the Irish State, the vast bulk of existing borrowings are at a fixed rate, so what is at issue is the cost of new borrowing. A figure to watch is when the cost of new borrowing moves above 1.5 per cent, which is the current average interest rate on our national debt. That is around where 10-year interest rates are now.
The ending of this special support will be followed by an interest rate rise, with ECB president Christine Lagarde recently refusing to rule out a rate increase this year. Markets now expect the ECB to increase its deposit rate twice this year, once in September and once in December, according to Dermot O’Leary, chief economist at Goodbody, Some analysts even see a risk that the first move could come over the summer. This would increase the deposit rate – which the ECB pays for overnight bank deposits – from minus 0.5 per cent to zero, or perhaps slightly into positive territory.
This is not the interest rate to which tracker mortgages are linked. That is the refinancing rate, currently at zero per cent, which analysts feel may not rise until next year. But by then the trend in rates will be upwards and rates on variable mortgages and on new fixed rate offers may be on the rise.
2. How far will interest rates go?
This is the big question – and a hard one to answer. Ever higher inflation figures, with a significant uptick in recent days, have seen an increase in financial markets’ expectations of the extent of higher rates. At the moment, O’Leary says, markets are pricing in euro interest rate increases of 0.7 percentage points this year and another 1.2 points next year, close to 2 percentage points in total. That would suggest interest rates starting to rise later this year, with a steady upward trend in 2023. These increases would be broadly reflected in variable rates, tracker rates and fixed rate offers to new borrowers. Those already on fixed rates would face more expensive options when their term ends.
There are three things to note here, One is that the war in Ukraine remains a huge uncertainty – by pushing up energy prices further it could spur inflation, but by hitting growth it could do the opposite. This has led many analysts to argue that the ECB should proceed cautiously in increasing rates – the underlying cause of inflation is not runaway demand and in fact there are serious threats to growth. But for now the argument that central banks must move seems to hold sway – the key is to try to knock expectations of a permanent rise in the inflation rate on the head.
But the second point to note is that – for now – expectations are for interest rates to remain at relatively modest levels by historical standards. Higher rates will hit borrowers, of course, though an environment where wages and house prices are rising will also bring some things in their favour. Inflation, even if it settles at a lower level of say 2 -3 per cent, will be a big change on recent years, when overall consumer prices have only crawled higher, even if the era of cheap money drove asset prices sharply upwards.
The final question is whether there is a risk of a sharper jump in inflation in the longer term and thus in interest rates. For now financial markets don’t expect this. And the longer-term trend in nominal and real rates has been downwards since the 1980s, drive by factors such as an ageing population and slower economic growth. So markets don’t see a big rise right now, but trends in rate expectations are worth watching closely. For now, investors are not quite sure what to make of the return of inflation.
3. How are borrowers reacting?
There are signs that borrowers are reacting to the threat of higher rates. Figures from the Banking and Payments Federation of Ireland show that mortgage switching rates are on the rise – up 42 per cent year on year in the first quarter. This is partly driven by the departure of Ulster Bank and KBC – but a search for value is also underway.
However, why consumers are switching – apart from the need to leave departing lenders – is an interesting question. Rather than a fear of higher interest rates, Karl Deeter, of Irish Mortgage Brokers, believes it is primarily driven by people facing tightening budgets and less spending power and deciding to reassess their main outgoings. And for many, switching can save money, with lenders offering attractive fixed rate offers, particularly to those where rising house values have reduced their loan to house value ratio.
This need to save cash has broken the inertia in which many are caught, Deeter believes. But borrowers are conscious of the threat of rising interest rates, too, and while mortgage rates are higher here than in most euro zone countries, rates of under 2 per cent for fixed periods of three to five years are available. The average rate on a new loan is 2.76 per cent.
Despite higher longer-term interest rates, borrowing costs here have not increased, bar in one or two cases. Deeter points to the favourable funding position of the main players, with large customer deposits and excess funds – on which they currently pay an interest rate penalty with the ECB. Together with the arrival of a couple of new players into the market in the months ahead, the market may remain competitive for now. However in time higher interest rates will be reflected in mortgage offers and in variable and later tracker rates. Those currently on trackers, however, are generally advised to hold tight as moving to another rate – while it may yield a cash bonus in some cases – is baking in significantly higher future repayments.
Daragh Cassidy, head of marketing at Bonkers.ie, agrees that competition may help to hold interest rates where they are in the Irish market, at least for the initial period of rising international borrowing costs.
“It will somewhat depend on the competitive pressure the banks feel under,” he said. For new borrowers, many of the lowest rates currently on offer are contingent on having a 40 per cent deposit, or a highly energy efficient home, or to be borrowing at least €250,000, he pointed out. But he adds that someone on a current higher rate could save very significantly by switching – and more and more seem to be doing so.