Irish Mortgage Brokers Blog

It has been a while since I posted on the yield curve, the main reason was that I lost my daily treasury letter from Bank of Scotland when all of their reporting went back to the UK and the daily replacement by Lloyds didn’t offer sufficient time-line to give a full curve.

The interesting thing that has happened in the interim is that the rules regarding forward rate prices between mortgage rates and Euribor rates has disconnected, in the same way that the ECB and Euribor disconnected in 2007, by this I mean that it is fascinating to see the established relationship end but the implications are horrifying for borrowers because it has meant that their monthly payments have gone up at a time the ECB is keeping rates low for the purpose of loosening up the financial cogs.

Take a look at the difference between February of this year and today, we can see that the long term rates are coming down and that flattening of the curve means two things: the ‘new normal’ is predicted to be one of sluggish growth, but it also sets the stage for price increases via inflation as money becomes very cheap and it tends to lead to liquidity reserves that can then find their way on the market rapidly. That is not happening at present, money supply is rising rapidly but there is no multiplier thus far, but that doesn’t mean it can’t happen.

What we are seeing is a comfortable connection as far as the one year mark, the reason the recent blue line is higher is due to the premium on interbank lending at present (everybody has to pay slightly more of late), the disconnect however, is from 12 months on at which point we see the significant shift in the yield curve and it looks set to flatten. This is coming at the same time as we see the 30yr German bond trading at a whopping 130 with a yield of c. 2.6%!

So the options at the moment are to run in fear to quality (Bund), or take risk, the German pricing is telling us that currently fear reigns supreme, but when that ends (perhaps ‘if’?) then we should see a significant wave of liquidity in the real economy, I just can’t tell you when. Perhaps it won’t happen? Banks around the world are extracting more and more out of the real economy, we’ll look at an Irish example.

We can see that the yellow line is significantly higher on the chart than the light blue line, that represents the shift in the mortgage rates versus the interbank rates. I’ll do one with arrows to make the picture clearer.

The gap is getting bigger, meaning banks are taking ever more money in and the recent lending figures by the IBF show that they are not in turn lending that money out. So the yield curve is working to the banks favour, normally this would be a golden opportunity, except for the fact that they are finding it expensive to raise funds because there is a premium on Irish banks and for that reason the gap is not as big (in reality) as it looks on paper. However, the fact remains that margins are going upwards and because of that the people who took long term fixed rates are going to win out because rates are going up independent of ECB.

Ireland has been a low rate country (versus the Eurozone) and now we are moving mid-table and in the future we will move higher, risk on Irish property will reprice in the same manner that our national bonds are repricing, although for slightly different reasons.

The lesson to take from this are: Fixed rates are yesterdays news, banks have jacked up the prices too far to make sense, the best time to move was in Q1 of 2009. Trackers are sitting pretty, don’t move off one without a really good reason, and lastly, variable rate holders are in for more pain, for them rapid deleveraging may be the only solution.

Sometimes talking about present values, par and yield to maturity will catch even a well versed practitioner off guard, but to see a pricing model in action helps and that is precisely what this video does - in this clip an assumed future rate is discounted into present values and we arrive at the bond price. Well worth watching (twice!).

Unless you are a cash buyer it isn’t a good idea to focus on property as a single cost, in a transaction there are two costs, that of the asset and then that of the finance for the asset purchase. I have done a few comparisons on costs where in two years time where a property has fallen a further 20% from where it is today.

As we expect margins on lending to rise considerably we have factored that in, along with moderate base rate increases. What we have done here is to take a view that prices may have fallen 40% from the peak to now, but they will fall a further 10% p.a. for the next two years, a further 20% from today or over 50% from the peak.

Purchase in 2010
€200,000 90% mortgage over 25yrs [€180,000] @ 4.5% [10yr fixed]
base rate 1% margin c.3.5%
repayment per month: €1,000
total cost: €300,000
balance after yr. 10: €130,785
Total Interest Paid by year 10: €70,845
Capital & Interest combined after 10yrs: €120,059

Purchase in 2011 (10% price drop)
€180,000 90% mortgage over 25yrs [€162,000] @ 6.5% [10yr fixed]
base rate 2% margin c.4.5%
repayment:€1,093
total cost:€328,150
balance after yr. 10: €125,568
Total Interest Paid by year 10: €94,828
Capital & Interest combined after 10yrs: €131,259

Purchase in 2012 ( 12% drop on 2011 or 20% price drop from 2010)
€160,000 90% mortgage over 25yrs [€144,000] @ 8% [10yr fixed]
base rate 3% margin c.5%
repayment:€1,111
total cost:€333,424
balance after yr. 10: €116,299
Total Interest Paid by year 10: €105,669
Capital & Interest combined after 10yrs: €133,369

What we can see is that the price of a property is one thing, but the cost of it is another, the price is dictated on the day of purchase (signing contracts really but in effect when you close), but the cost for non-cash buyers is dependent on the interest rates involved.

We can see that if margins (using the 10yr fixed rate) were to go from 350 basis points to 500 (which is only 1.5% more and totally reasonable within the 2-3yr time frame) while base rates moved somewhat conservatively as well that the reduced price doesn’t save that much in terms of monthly costings, in fact, the gain on the reduced capital sum is virtually the same as the additional cost, but (for me anyway) I’d rather have increased cash flow versus having a reduced capital sum - within reason of course!

Could this really happen? Take a look at the Euribor yield curve below, it is pricing in rate increases, but because this is market based and not from the ECB itself we can only use it as a guide, having said that, it is a guide based upon millions of transactions so perhaps it is as ‘real’ as it gets.

That banks will increase margins is a given, and people have a tendency to believe rates will stay low and they don’t look across the curve, if they did then lots of people would have been fixing their rates in 2004 but instead they went for fixed rates predominantly from 2005 onwards when rates were in an upward cycle and the upswing was already priced in! The reward for huge groups who made that decision was not only negative equity, but a higher financing cost in the process!

This doesn’t mean property is in some widespread recovery, but it is a reminder to people that ‘property prices’ are not the only consideration in buying, if you could book a rate today and get it in two years that might be ideal, but because that isn’t possible then don’t forget to consider costs as well as prices.

One of my favourite tools is that of the Yield Curve, in the US they look at the Treasury Curve and the TED (Treasury/EuroDollar), in Ireland we use the Euribor, and what the curve tells us is the interbank cost of borrowing money, or I should say that is what it represents because it can actually tell so much more. It is a market mechanism that gives an indication of what the belief is in the market towards inflation, interest rates and cost of funding, this isn’t opinion, it is derived from real money flowing around the world and that is why I like it, the Yield Curve doesn’t lie.

So we’ll take a look at what has been happening in the last month.

We see something interesting here, the short term expectation is that rates will remain low, in fact, with deflation still a fear the short-term working money (banks generally run off the 3 month) is getting cheaper of late. The divergence occurs after the 12 month mark, so essentially in a year the change in expectation in the last month is that rates will start to go up by more than what was expected in December, that is where the blue (jan 2010) line breaks away from the purple (dec 09′) one.

What does that indicate? For a start it means that for the next 12 months nobody is overly concerned about a rate hike, we keep hearing it in the press but in the market there is nothing within the next 12 months that spells that out, if there was (and it’s not to say that things can’t or don’t change - quite rapidly at times) you’d see a much steeper curve arising. The other thing we can take from it is that between the 12 month and 2 year mark a rate hike is expected, part of the increase in price at that point is uncertainty, the longer you look out the more uncertain it gets, but the basics of it are that rates will rise at some point after a year from now.

Month to month trends are not the most telling, we can get a clearer picture if we compare several months - not for a secular image but for a cyclical expectation, so here is a chart showing mid Q3 to Q4 and the start of Q1.

What we can see is that in general, the fear of inflation or costing of it into the market, has dropped since August 2009. There has been some consolidation ever since then,you will see that again, they all have a similar expectation up to the 12 month outlook then the expectation changes. November to December saw expectations drop on prices further out, but since then (with fear of ECB reductions in liquidity provision) it rose higher in January 2010.

Oddly, this curve and the steepening of it is good news for banks, they can borrow very cheap on the short term and get a higher rate of return in Bonds (note: lending is likely to reduce because the risk free rate is better), or they can use that steep end to price out higher fixed rates and then go to the swap market.

One way or another, the big question seems to be pegged (recently) to the one year mark, I think that we may be surprised in 2010 by the ECB not increasing rates or doing so only enough to placate the Germans and French (c. 25 basis points).

On the deposit side it means that you can expect banks to drop the rates they are willing to pay depositors, other than banks which are cash hungry, and what many of them will do is offer out a rate then go to the risk free market (sov. bonds) and place it there, in any case, the short term outlook isn’t one where you can expect a credit multiplier, having said that, if and when that comes it may turn out to be pretty impressive.

I hope you can see now why we watch the yield curve so closely! It is a fairly decent compass when you take the time to look at it and compare it over time, I just hope you haven’t already fallen asleep at this stage!