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Get ready for the pain of higher interest rates


Fed chair Janet Yellen has stated that the US central bank will start raising rates, probably in September. Photo: Carlos Barria/Reuters

Fed chair Janet Yellen has stated that the US central bank will start raising rates, probably in September. Photo: Carlos Barria/Reuters


Fed chair Janet Yellen has stated that the US central bank will start raising rates, probably in September. Photo: Carlos Barria/Reuters

With the Fed due to start raising US interest rates in September, the long period of ultra-low interest rates which we have enjoyed since the 2008 global economic crash is now drawing to a close. This will have major implications for Irish homeowners, businesses and the Exchequer.

The official ECB interest rate currently stands at a mere 0.05pc, the Federal Reserve's rate is just 0.25pc while the Bank of England's official rate is 0.5pc. The interest rates being charged by the world's major central banks have never been lower, lower even than during the Great Depression of the 1930s.

And it isn't just official central bank interest rates - which largely determine short-term rates - that look set to rise. Bond yields, the main determinant of long and medium-term rates, have also been abnormally low in recent years as central banks purchased massive amounts of bonds - so-called quantitative easing.

At the peak of the bond bull market in mid-April, a third of the of Eurozone's $6trn government bond market was trading on negative yields - meaning investors were prepared to pay governments for the privilege of lending them money. This was plainly an absurd situation.

After almost seven years it would be easy to take abnormally low interest rates for granted. Bad idea. Already the bond boom has turned to bust, with bond prices down and bond yields up sharply.

The yield on ten-year German government bonds, which had fallen to just 0.06pc by mid-April, was up to 0.83pc this week. US bond yields have also been rising with the yield on ten-year Treasuries climbing from 1.68pc at the end of January to 2.38pc this week.

Now central banks are getting ready to raise official interest rates. Fed chair Janet Yellen has stated that the US central bank will start raising rates, probably as soon as September. Investors have already pencilled in the September rate increase by the Fed, probably 0.25pc, and most are now expecting a second 0.25pc rate hike in December.

It will be a while longer before the ECB raises rates but it is no secret that the German central bank, the Bundesbank, has been pressing for higher Eurozone interest rates to prevent the German economy from over-heating. However, even before the ECB makes its move, higher bond yields will push up medium and long-term eurozone interest rates.

So what does all of this mean for us here in Ireland? One of the lasting consequences of the death of the Celtic Tiger has been the decoupling of Irish interest rates from official ECB rates - what the ESRI's Professor Kieran McQuinn calls "the wedge".

The impact of this wedge is clear for all to see with the most recent Central Bank figures showing that many homeowners and SMEs are paying extremely high interest rates, despite very low official ECB rates.

Homeowners with variable rate mortgages are feeling the pain of this decoupling. They are paying an average interest rate of 4.26pc while buy-to-let borrowers are paying 4.35pc.

However, things could get an awful lot worse if interest rates rise. While variable rate mortgage customers have been clobbered by interest rate rises in recent years, those on tracker mortgages - where the interest rate charged by the lender is tied to the official ECB rate - have been protected.

At least up to now.

According to the Central Bank, the average interest rate paid by borrowers with trackers on their principal private dwellings is just 1.05pc while those with trackers on buy-to-let properties pay a mere 1.02pc.

And there are an awful lot of trackers out there. The Irish banks were managing over €114bn of mortgages at the end of March, of which €77.6bn had been retained by the banks and €36.7bn had been securitised - or sold on to investors.

A total of €36.5bn, almost half, of the mortgages which had been retained by the banks are trackers. Trackers make up an even higher proportion of the securitised mortgages, €22.2bn or 60pc. Add it all up and the €58.7bn of trackers outstanding account for just over 51pc of all mortgages.

What happens to these tracker mortgages when interest rates start to rise? While it might seem counter-intuitive, borrowers are more vulnerable to rate rises when interest rates are low than when they are high.

Someone on a 25-year €200,000 tracker mortgage on the average 1.05pc tracker rate is currently repaying his or her bank €758 per month. A 1pc interest rate rise would push the monthly repayment up to €852, an increase of €94 per month.

The same monthly repayment would service a variable rate mortgage of €140,000 at the current average variable rate of 4.26pc. If interest rates were to rise by 1pc the repayments on the variable rate mortgage would climb to €839, an increase of €81 per month.

Unfortunately the Central Bank's mortgage arrears statistics don't distinguish between arrears on trackers and those on variable rate mortgages. However, it seems reasonable to assume that a sudden sharp rise in ECB rates would push the recent decline in mortgage arrears into reverse.

Davy banking analyst Emer Lang says that the impact of rate rises on the banks and their tracker customers will depend on the state of the economy when rates go up, the magnitude of any rate increase and its timing.

"A series of small rises would be easier to manage than a single sharp rise", she says.

No matter how one chooses to look at it, tracker mortgages are potentially the ticking timebomb buried in the basement of the Irish banking system. Although the banks have sold off many of their mortgages, in at least some cases the securitisation agreements specify that the selling bank must take back any loans that go sour.

SMEs will also be hit hard by any increase in interest rates. They too have suffered the pain caused by the decoupling of Irish bank interest rates from official ECB rates.

A construction company seeking a new bank loan can now expect to pay an interest rate of 6.64pc - always assuming that it can persuade the bank to loan it the money. SMEs in other sectors are also being hit with punitive interest rates, with transport companies paying an average interest rate of 6.22pc; water, sewerage and management companies 5.23pc; business services firms 5.17pc and wholesale and retail businesses 5.01pc.

Irish SMEs are currently benefiting from a combination of low interest rates, cheap oil and a weak euro, says ISME chief executive Mark Fielding. This triple whammy clearly isn't going to last forever.

"Companies need to be factoring in an interest rate increase, that the currency will rise and that oil will get dearer," he says. Mr Fielding also urges companies who are negotiating debt restructurings with their banks to get it done as soon as possible. For some financially stressed companies, an interest rate increase could be the "torpedo below the water-line" that finally puts them out of business, he says.

Higher interest rates will also have implications for the Exchequer and the economy as a whole. Despite the talk of tax cuts in next October's budget, Ireland remains a highly-indebted economy with both public and private sector borrowings still at extremely high levels.

According to the NTMA, Ireland's gross national debt stood at just under €200bn at the end of May. And an international survey published last February by management consultants McKinsey calculated that, at 390pc of GDP, Ireland's total borrowings - private as well as public - were the second-highest in the world after Japan (where it's 400pc of GDP).

This very high level of borrowings leaves us extremely vulnerable to any a rate rise. At €200bn, a 1pc rate rise adds €2bn a year to the cost of servicing the national debt - comfortably more than the €1.5bn Finance Minister Michael Noonan is planning to give away in tax cuts and spending increases in the budget. Irish bond yields have already risen sharply with the yield on 10-year Irish government bonds jumping from 0.7pc in mid-April to 1.63pc this week, an increase of 93 basis points (0.93pc).

While the NTMA has locked in some of this year's record low yields, meaning that the full impact of higher bond yields will not feed through into the budgetary arithmetic immediately, higher bond yields do cast a shadow over the Irish public finances.

With both the Fiscal Advisory Council and the IMF urging the Government to do more to cut borrowing, next October's "giveaway" budget is almost certainly going to prove to be a pre-election once-off rather than the first of many. Fiscal discipline will be resumed after the election - no matter which parties are in power.

Even if the ECB doesn't move to increase rates soon, that isn't necessarily good news. The reason both the Fed and the Bank of England are now preparing to raise rates is that the American and British economies are now growing strongly and their central banks are acting to head off the threat of inflation taking root.

If only we had that problem in the Eurozone. While the Irish and German economies are performing well, it is different story in most of the rest of the single currency bloc. Professor McQuinn says that he is "very pessimistic" for the eurozone's prospects.

So with the domestic banks having already jacked up their variable rates, and higher bond yields set to feed through into increased medium and long-term interest rates, the sugar rush which the Irish economy has enjoyed from record low interest rates may already be wearing off.

The future is likely to be one of dearer money, higher taxes and lower growth - even before the ECB raises its official rates.

Sunday Indo Business