It seems almost certain at this point that the European Central Bank will raise interest rates in July for the first time in over a decade.
The deposit rate, which has been negative for eight years, will probably be the first to tip over with a return to zero.
The key borrowing rate – currently at zero – will follow or may even change at the same time.
Even before the ECB shifted gears, lenders began to raise the rates they seek for fixed-term loans.
Although much emphasis has been placed on the impact that rate hikes will have on individuals with mortgages and other forms of debt, shifts in the global interest rate environment are already driving up the costs of government borrowing.
Ireland is not immune to this shift in global debt dynamics.
Bonds in the era of QE
The National Treasury Department organized an auction of short-term debt on Thursday.
The interest rate payable on the bonds – which mature in October – was -0.25%.
In other words, the holders of these bonds are effectively paying the state for holding this debt – not the position a bondholder expects to be in.
Ten years ago, this situation would have been unimaginable.
Ireland had been shut out of the debt markets following the financial crash that led us to turn to the troika of the European Commission, ECB and IMF for a bailout.
Over time, we regained credibility with international lenders and gradually returned to the bond markets, borrowing at relatively high prices.
As confidence grew and the European Central Bank embarked on a policy of buying billions of euros in government bonds each month – a practice known as quantitative easing, or QE – the cost debt servicing for governments across Europe has dropped dramatically.
The intention behind this policy was to encourage governments to borrow more at lower rates to fuel their economies in the aftermath of the financial crisis and to try to stimulate spending and bring some inflation back into the system.
This cost of borrowing has come down further during the pandemic as the European Central Bank extended policy and began buying back even more debt to encourage governments to borrow to support their economies during lockdowns.
The Irish state has benefited greatly from this broader policy, guaranteeing ten-year debt at essentially negative rates in recent years.
The situation has changed dramatically in recent months.
Faced with soaring inflation in the euro zone, the ECB announced its intention to quickly conclude its bond purchase programs over the next few months.
And he is firmly on the path of interest rate hikes – some would say too late in the day.
The effect of this is already apparent in debt markets.
Steadily rising since the start of the year, the price paid by the Irish government to borrow on the bond markets has effectively more than doubled since March.
The yield – or interest rate – of ten-year debt is around 1.6%.
It is the highest cost of borrowing over this period for the Irish state since 2014.
“By historical standards, it’s still very cheap,” Ryan McGrath, head of fixed income strategy and sales at Cantor Fitzgerald, said as background.
He pointed out that the National Treasury Management Agency had canceled a bond auction scheduled for June, which he interpreted as an indication that the state was considering reducing its borrowing plans for this year.
“The NTMA released a financing statement at the beginning of the year giving a range of what they can borrow from 10 to 14 billion euros. Historically, they have gone for the middle of the range, if not the top. This year, they will be at the very bottom, after 10 billion euros,” he predicts.
“It looks like Ireland will borrow less in the future, but at a higher rate,” he concluded.
The national debt here stood at just over 237 billion euros at the end of last year.
It has increased by almost 20 billion euros compared to the end of 2020, as the government continues to borrow much more than normal to finance support linked to the pandemic.
Although this is a very large debt in terms of real euros, it is generally considered in the context of the wider economy.
As a proportion of our GDP, it amounts to 56%, which is considered a very manageable debt.
Judging against an indicator of economic growth favored by the Central Statistics Office – a measure known as GNI* – the debt ratio stands at 102%.
Ryan McGrath said Ireland’s debt metrics were among the strongest in Europe, reflected in ratings agency Moody’s recent decision to raise Ireland’s sovereign credit rating.
“We are now double A in the four major rating agencies,” he said.
Anything that falls into Class A is considered high quality, which means the debt issuer has a high chance of meeting its obligations.
Gerard Brady, chief economist at Ibec, agrees that Ireland is in a relatively strong position when it comes to debt dynamics.
He points out that the NTMA has taken advantage of the low interest rate environment to bring the overall cost of servicing the national debt down to very low levels in recent years.
The hit will come to future borrowing, he points out, but he said the government should be able to sustain a fairly sustained rise in interest rates over the next few years, as long as a number of conditions are met.
“You would need to see borrowing rates at high levels for an extended period – around the 4 or 5% mark – to see real pressure on the government’s interest bill, as long as we don’t register no big deficits,” he explained.
How high could government borrowing costs go?
It seems virtually certain that interest rates will rise in the months and years ahead, putting upward pressure on the cost of borrowing for individuals and governments alike.
Besides the base rate at the ECB and bond market fundamentals, much depends on a country’s perceived reliability and ability to service its debt.
The riskier a country is perceived to be in terms of borrowing, the higher the interest rate usually attached to the debt.
This is not an issue the government should be concerned about at this time, but for some countries it could be a problem.
“As the ECB retreats, you can see bond yields spread,” said Gerard Brady.
“All the talk about structural reform was actually just a ruse of the ECB doing so much buying [of bonds] in Europe,” he explained.
Division of debt
Attention will likely return in coming years to the so-called “spread” between German borrowing costs and the rate applied to other countries.
This could see a resurgence of tensions between countries over what is considered an appropriate interest rate and the view of southern European states that the ECB needs to do more to help them.
“Italy got bigger, but was pretty orderly,” Ryan McGrath said.
“There were no major shocks. The Italian-German gap is around 2%. What the ECB wouldn’t want is a volatility shock where Italy would explode very strongly and sustained,” he said.
Investors have generally been reassured by Italy’s relative political stability since Mario Draghi became prime minister early last year.
Some fear that this stability will be disrupted in the elections next year.
Already faced with inflation, rising interest rates and the prospect of a recession, the last thing the ECB wants right now is the prospect of another debt crisis in Europe.
Crisis or not, what is certain is that we are entering a new era of high interest rates that a whole generation of Europeans will never have known in their lifetime.
“The scale of the interaction in the economy has been huge and as that recedes and normalizes, it’s going to feel very different,” Gerard Brady said.
“We’ve been through this unreal period in terms of interest rates. For now, we seem to be returning to a pre-financial crisis reality of rising rates, at least in the short term,” he said. concluded.