Eurozone house prices are set for a correction as interest rates start to rise in response to higher inflation, posing greater risks for low-income households, the European Central Bank has warned.
A reversal in the region’s housing markets was one of the main risks identified by the ECB’s twice-yearly financial stability review, which also warned that Russia’s invasion of Ukraine meant more companies were likely to default due to lower growth, higher inflation and rising borrowing costs.
Predicting that asset prices could fall further if economic growth continues to weaken or inflation rises faster than expected, the ECB said a sharp increase in rates could cause a “reversal” in eurozone house prices, which it estimated were already about 15 per cent overvalued, when weighed against overall economic output and rents.
The central bank is gearing up to raise its deposit rate in July for the first time in a decade and markets expect four quarter-point rises this year, which it said “could challenge the valuations of riskier assets, such as equities”.
Mortgage rates in the eurozone have already been rising since the start of the year. The ECB’s composite indicator of the cost of borrowing for house purchases rose from a low of 1.3 per cent last September to 1.47 per cent in March.
“An abrupt increase in real interest rates could induce house price corrections in the near term, with the current low level of interest rates making substantial house price reversals more likely,” the ECB said.
House prices rose almost 10 per cent in the eurozone last year, the fastest rate for more than two decades, according to data from Eurostat, the European Commission’s statistics bureau. They could fall between 0.83 and 1.17 per cent for every 0.1 percentage point increase in mortgage lending rates, after adjusting for inflation, the ECB calculated.
The Bundesbank recently warned that German banks were becoming too complacent about the risk of borrowers defaulting and the potential for interest rates to rise, pushing up the amount of capital lenders must put against their mortgages.
“We think the German housing market is likely to peak in the next couple of years, probably around 2024, though it could be much earlier if we have an interest rate shock,” said Jochen Möbert, an analyst at Deutsche Bank Research.
Rising interest rates are likely to prompt institutional investors to shift money they have been putting in property back into the German bond market, Möbert said, predicting this was likely to happen when Bund yields rose from 1 per cent currently to between 2 and 4 per cent.
“Rental yields are below 4 per cent in German cities on average and in the metropolises they are lower, in some cases they are even at 2.5 per cent, so once risk-free rates reach that level it would make sense to switch back to Bunds,” he added.
The central bank said a shift towards fixed-rate mortgages would shield many households from the immediate impact of higher borrowing costs.
Richer households would also be able to cushion the hit by saving less or drawing on extra savings accumulated during the coronavirus pandemic, it said. However, it warned that this would leave low-income households “more exposed to the inflation shock”.
The ECB said its recent “vulnerability analysis” of the banking sector had shown that it was “resilient to the macroeconomic ramifications of the war in Ukraine”.
Banks accounting for more than three-quarters of assets in the sector would maintain a core capital ratio above 9 per cent in its “severely adverse scenario”, in which the eurozone economy would shrink for the next three years, the central bank said.
Higher interest rates are expected to boost banks’ lending margins in the short term. But Luis de Guindos, vice-president of the ECB, warned that “in the medium term the situation might be different”.
De Guindos said banks’ profit margins could be eroded by a “duration gap” between rising short-term funding costs for banks and their longer-term loans, such as mortgages, that lock in low rates for many years.
He admitted the ECB had been “too pessimistic” in its 2020 warning that the fallout from the pandemic could cause a €1.4tn increase in non-performing loans for banks, which did not materialise as bankruptcies fell instead thanks to massive state support.
However, he said higher inflation and rising borrowing costs could cause some companies that have already been weakened during the pandemic to slide into default. “Perhaps the insolvencies that did not take place during the pandemic could, at least in part, take place now,” he added.