CBRE EMEA MarketFlash: More QE in Europe for now but higher interest rates are on the way

On Thursday (8 December), the ECB extended its asset purchase scheme (QE) until the end of 2017 as expected, but it surprised markets by reducing monthly purchases from €80 billion to €60 billion per month beginning in April 2017.This move gives a partial signal to the market that the ECB is not about to withdraw support from the bond market in the near future and reaffirmed its commitment to low long-term interest rates, no matter what the signals coming from the United States (in the form of rising yields on long-term Treasuries). At the same time, the ECB has signalled that a taper is on the way. This reflects the dilemma faced by the ECB: the need to re-assure the markets (in the face of increased political uncertainty and rising US interest rates) on the one hand, and on the other, growing dissatisfaction with the distortions caused by a zero/negative interest rate policy and quantitative easing (QE) especially now that inflation is expected to be approaching the ECB’s target by the end of 2017. German government and monetary authorities as well as European banks have been particularly vocal in complaining about current policy.In our view, the implications for property are:

  • 2017 will likely see a modest upwards drift of long-term interest rates though not as steeply as seen over the past month. We expect 10-year German bund yields to be in the 0.40 to 0.45% range at the end of 2017, up from 0.20 to 0.39% seen over the past two weeks.
  • Further rate increases are anticipated in 2018 when further tapering occurs when the new scheme expires. German 10-year bund yields are expected to reach 0.9% by the end of 2018. These increases will be modest compared to the expected rise in US rates but represent a substantial change from the negative yields recorded as recently as October.
  • Although there is a well-established link between long-term interest rates and prime property yields in the long run; the short term relationship is less clear. Indeed, we expect further yield compression in many of the main European markets over the course of 2017. This is due to lags in decision making and the weight of capital trying to enter the market. It also reflects the current strength of many occupier markets and the prospect of increasing rents especially in core (particularly German cities and Stockholm) and cyclical recovery (particularly Spanish cities) markets.
  • There is only limited scope for further yield compression in the most expensive markets but we expect to see a concertina affect in 2017 with other prime yields moving in behind the ultra-low yields currently being achieved in core markets.
  • Longer term, rising interest rates will inevitably put pressure on yields but the large gap that has opened between prime property yields and government bond yields in recent years provides a substantial safety cushion. As a result, the increase in property yields will be less pronounced than the increase in government bond yields as the spread returns to more “normal” pre-QE, pre-recession levels.
  • Although not part of the single currency, UK government bond yields are expected to follow a similar trajectory. Prime UK property yields, however, are more likely to be influenced by Brexit-related uncertainty over the next few years and so their future movement will be out of sync with European prime property markets.