Interest rates are heading down. But will your mortgage rate fall?

The ECB's official interest rates are already at zero – or lower. Yet this week Mario Draghi, the European Central Bank president, hinted they may fall further, while US rates may also be heading downwards. This is a complete reversal from what was expected earlier this year. But how on earth can the ECB cut rates that are already at rock bottom? And what does it mean for Irish borrowers – and for the economy?

1. What just happened?

We may well look back on this week as a key turning point. Mario Draghi, coming towards the end of his term, used an ECB conference in Sintra in Portugal to send out a clear message to the financial markets. The ECB is uncomfortable with the economic data and particularly inflation. The euro zone inflation rate fell back to 1.2 per cent in May, with little sign of an increase towards the ECB target of 2 per cent.

“In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required,” Draghi said, adding that the ECB will consider the issue in the “ coming weeks” and will use all the flexibility within its mandate. In the obtuse language of central banking, that was akin to sounding the alarm bell. Loudly. The ECB is worried and is preparing to act.

Nor is it on its own. The Federal Reserve Board, the US central bank, clearly indicated at its meeting this week that it, too, was looking at reversing policy and will, if necessary, reduce its interest rates in the months ahead. Fed chair Jay Powell did, however, say that it would wait to see what the evidence showed ahead of its next meeting at the end of July. A US cut looks likely, but is not a foregone conclusion.

How do you know if your property tax bill is going to go up?

---

The outlook for interest rates has changed dramatically - here is what it means

---

Carbon tax: sharp rise in fuel costs on way - but then you get your money back

---

Is Ireland’s low rate of repossession the reason mortgage rates are so high?

---

The reasons big central banks are spooked is that there seems no end to the era of low inflation – and slowing growth threatens to weaken price pressures further. The big fear is a lapse into a damaging period of very low inflation or even deflation, which is economically damaging and very hard to escape from. The view is that it is better to act now than run this risk. “An ounce of prevention is worth more than a pound of cure,” as the Fed chairman put it.

All of this means things have changed substantially in recent months. As Simon Barry, Ulster Bank's chief economist in Dublin points out: "As recently as late-January this year, the ECB was guiding that a still – at that stage – solid-looking euro zone economic outlook meant that interest rates were likely to be raised by around September of this year." After a succession of gradual changes in this guidance, it is now pointing to more stimulus and a possible rate cut.

2. What can the ECB do?

Draghi did not outline exactly what the ECB would do and this may be a matter of some tension at the governing council, where a German-led group has argued strongly for the withdrawal of the extraordinary stimulus introduced during the crisis.

The ECB has a number of options. It could resume its massive programme of quantitative easing, buying bonds – largely issued by governments – as a way of injecting cash into the euro zone economy. It started to wind down this programme at the end of last year, but the ECB still has massive amount of cash from maturing bonds to reinvest and could decide to increase net buying again. This may require changes in the rules about how much sovereign debt it can buy.

The ECB could also ramp up the programme under which it provides cheap financing to banks – called TLTRO (targeted longer-term refinancing operations). The next round of these loans is due to be issued in September.

Then there is the interest rate option. The ECB has two main official rates – the refinancing rate currently set at 0 per cent and the deposit rate at minus 0.4 per cent. The latter is what it pays banks who are obliged to leave cash with it on deposit or, at the moment, what they pay the ECB for the privilege

While the main refinancing rate tends to get the headlines, the deposit rate is key in terms of market interest rates and, if there is a rate move, it may well be the one that is edged further downwards. According to Barry, while much will depend on indicators in the weeks ahead, financial markets are increasingly convinced of a deposit rate cut, with a drop of 0.1 to 0.15 percentage points currently priced in “with speculation building that a cut could come as soon as September.” This would mean Draghi ending his term as he started it – with a cut in interest rates.

Economist Dan McLaughlin, in a blog on the interest rate outlook, says that the ECB could consider new approaches in terms of the interest rates paid to banks who deposit money with it, offering a higher rate on some loans to try to ensure that a further cut does not undermine bank profitability, while still cutting the lowest rate on offer.

3. What does this mean for borrowers ?

The first thing to say is that the prospect of an early interest rate rise is completely off the table. Early this year there was speculation that ECB base rates might edge up late this year or in early 2020. Now markets do not foresee any increase in the main refinancing rate for a prolonged period, though some caution is needed here, as these expectations can quickly adjust,as we have seen.

The ECB looks unlikely to cut its main refinancing rate – the one currently at zero per cent. This is the one from which tracker mortgages, held by around 40 per cent of borrowers, are priced. So tracker rates are unlikely to fall, and should remain at their current rock bottom level for a considerable period into the future. A tracker remains a valuable commodity for the borrowers lucky enough to have one.

A cut in the ECB’s deposit rate – or other measures adding cash to the euro zone economy and pushing market rates lower – could, however, push other lending rates down a bit. Banks would be able to raise borrowings more cheaply and this should be reflected in a nudging down in fixed rates, now a key area of competition in attracting new lending. These have fallen in the last few years mainly due to increased competition, as opposed to money market moves, with shorter-term fixed rates from two to five years now a key area of competition. But they could now go a bit lower, as could the longer-term fixed rate offers of up to ten years.

Two-year fixed rates are now available at rates as low as 2.3 per cent in some cases, with the best five year rates around 2.75 per cent. The low rate environment should encourage more lenders to match the best offers in the market and may even lead to the lowest offers edging lower.At a time when standard variable rates are over 3 per cent, these fixed offers are attracting the bulk of new borrowers.

There could also be some downward pressure on standard variable mortgage rates. And, as with tracker rates, any talk of a rise in these rates is now off the table for a prolonged period. This is important for those going into shorter-term fixed rate contracts now – the outlook for when they come off fixed rates, certainly shorter term one or two year products, has now improved.

"Whatever about what the ECB actually say, the markets are assuming that low rates are here to stay," says Karl Deeter of mortgagebrokers.ie. The outlook for borrowers is interesting he said, with over-funded banks having cash to lend, arguing for lower interest rates. However capital requirements on the banks and their slow emergence from the crisis have left rates here still well above the EU average.

“There is still room for rates to fall but lenders won’t do it until somebody moves first, so the question is who will that someone be?” Deeter says. Some banks continue to compete partly via cashback offers rather than purely the basic interest rate they offer.

Deeter advises borrowers to grab the lowest rate they can – often now a fixed rate. Borrowers should always check for an explanation of break fees to get out of fixed rate loans, he said, “because in many cases they are zero which means you can beat the bank by taking a cheap fixed rate today then moving to a cheaper rate elsewhere later on even during a fixed rate because the cost of leaving is nil.”

4. And for the economy?

Lower rates hit savers, but given the high level of debt held by many households – and by the State – the fact that interest rates are not going to rise and could edge down removes a risk to the economy. ESRI research has pointed to the risk for mortgage borrowers of higher rates, which it said could threaten repayments in some cases and push some borrowers into arrears. Meanwhile the Government is able to raise finance on the markets at close to record low interest rates, with 10-year borrowings raised last week at just 0.3 per cent and shorter term loans available at negative interest rates. This helps to push down the overall cost of financing the national debt, yielding significant gains for the exchequer.

5. What should we watch?

The economic signals will be vital in the weeks ahead in terms of the pressure on the ECB to act – and it is also worth watching the internal politics as Draghi’s term comes to an end and a successor is chosen. Fears of trade wars are seen as important in dampening investment and growth in recent months and so a meeting between the US and Chinese presidents at the G20 meeting in Japan next week will be closely watched. Donald Trump’s angry reaction to Draghi’s announcement this week – saying it was unfair to the US as it weakened the euro against the US dollar – shows just how tense the international atmosphere is. With growth in the US and euro zone already slow, any further hit from a trade war would concern central banks.

And we saw from Trump’s tweets that there is a danger of trade tensions spreading into currencies, as he puts pressure on the Fed to cut rates to keep the dollar low and help US exporters.

The final issue is that of central bank credibility to tackle the era of low inflation. Rock bottom interest rates have only had a limited impact– and further puts may not do much to help. The problem is not so much lack of cash – there is loads of it around – but a lack of demand to borrow it.