ECB warns house price correction looms as interest rates rise

House prices in the eurozone are ripe for a correction as interest rates begin 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 real estate markets was one of the main risks identified by the ECB’s semi-annual financial stability review, which also warned that the Russian invasion of Ukraine meant more companies were likely to default due to lower growth, a higher inflation and higher 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 rise in rates could cause a “pushback” in house prices in the eurozone, which he estimated were already 15 percent overvalued. when compared to overall economic output and rents.

The central bank is preparing to raise its deposit rate in July for the first time in a decade with markets expecting four-quarter-point increases this year, which it said “could challenge valuations of riskier assets such as the actions”.

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Mortgage rates in the eurozone have already been rising since the beginning of the year. The ECB’s composite gauge of the cost of borrowing for home purchase rose from a low of 1.3 percent last September to 1.47 percent in March.

“A sharp rise in real interest rates could induce short-term house price corrections, and the current low level of interest rates makes substantial house price reversals more likely.” said the ECB.

House prices rose nearly 10 percent in the eurozone last year, the fastest rate in more than two decades, according to data from Eurostat, the European Commission’s statistics office. They could fall between 0.83 and 1.17 percent for every 0.1 percentage point rise in home loan 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 possibility of interest rates rising, raising the amount of capital lenders must put up against their mortgages.

“We think the German real estate market is likely to peak in the next couple of years, probably around 2024, although it could be much sooner if we get a hit on interest rates,” 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 into property back into the German bond market, Möbert said, predicting this will likely happen when Bund yields rise from 1 percent. current percent to between 2 and 4 percent. .

“Rental yields are below 4 percent in German cities on average and in metropolises they are lower, in some cases even at 2.5 percent, so once risk-free rates reach At that level, it would make sense to go back to the Bunds. ”, he added.

The central bank said a shift to fixed-rate mortgages would shield many households from the immediate impact of higher borrowing costs.

Wealthier households could also cushion the blow by saving less or tapping into extra savings built up during the coronavirus pandemic, he said. However, she warned that this would leave low-income households “more exposed to the inflationary shock.”

The ECB said its recent “vulnerability analysis” of the banking sector had shown it to be “resilient to the macroeconomic ramifications of the war in Ukraine”.

Banks that account for more than three-quarters of the sector’s assets would maintain a core capital ratio above 9 percent in their “severely adverse scenario,” in which the eurozone economy would contract over the next three years, the central bank said.

Higher interest rates are expected to boost banks’ credit spreads in the short term. But Luis de Guindos, Vice President of the ECB, warned that “in the medium term the situation may 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 long-term loans, such as mortgages, which lock in low rates for many years. years.

He admitted the ECB had been “too pessimistic” in its 2020 warning that the fallout from the pandemic could cause a €1.4 trillion rise in non-performing loans for banks, which failed to materialize as bankruptcies fell. 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 default. “Perhaps the insolvencies that did not happen during the pandemic can, at least in part, happen now,” she added.

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