Interest Rate

The interest rate is a percentage of the principal the borrower needs to pay in exchange for the borrowed amount. One can say that the interest rate is an expression of how much it costs to borrow money in today’s value. As most real estate transactions are financed by borrowed money, one can say that the interest rate is one of the most important fundamentals. For example, if the nominal interest rate

29 decreases it becomes cheaper for people to borrow money, which will lead to increased demand as more people will be able to afford real estate. Likewise, if the nominal interest rate increases demand will fall as it will get more expensive to borrow the money to finance the transaction (André, 2010). Changes in the interest rate are not only interesting for people who are entering the real estate market. If an individual has chosen a mortgage that has an adjustable interest rate an increased interest rate can affect them very much as well. If the interest rate increases too much, some people will be forced to sell their homes and the supply of houses will increase. When supply goes up and demand is kept stable, the price of the overall real estate market will fall in the short run. From a historical perspective, the interest rate is also interesting as low interest rates levels had a major impact on the outcome of the financial crisis (Rangvid, 2013).

The long-term interest rate is based on mortgage bonds with a maturity above 10 years while the short-term interest rate is based on mortgage bonds with a maturity of only one year. I chose to analyze two different interest rates because the long-term interest rate is a proxy for fixed interest rate mortgages, while the short-term interest rate is a proxy for adjustable interest rate mortgages.

In Figure 11, one can see the real effective interest rates based on quarterly observations for long-term mortgage bonds and short-term mortgage bonds since 1992. The data series is based on data from two different datasets where the data prior to 1997 is somewhat different from the data after 1997. This is due to the introduction of adjustable interest rate mortgages in 1996 by Realkredit Danmark (Finanstilsynet.dk, 1996). Before this point, a mortgage was solely based on a long-term mortgage. The data series from 1992 until 1997 was calculated from the working paper “Danish Economy; Monetary Conditions; Inflation, Wages and Prices; the Money and Currency Market” (Nationalbanken.dk, 2016) as an average of the author’s three defined ‘short-term’ interest rates. These are the official interest rate, the private bank’s average deposit rate and the market rate of discounts. This data series is based on yearly data and I was forced to assume that the effective interest rate was the same during all four quarters of the year.

The data from 1997 and onwards is based on Finans Danmark’s official publications about short-term and long-term interest rates. It was published as weekly observations and I converted it into quarterly data as a simple average of the period. Lastly, the effective interest rate was converted into the real effective interest rate.

Equation 4: The Real Effective Interest Rate from 1992 until 2020 𝑅𝑒𝑎𝑙 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 =1 + 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒

1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 − 1 Where the inflation rate is the same as that defined in section 4.2

30 When looking at Figure 11, there is clearly a correlation between the two interest rates. This makes

intuitive sense, as if there were no correlation there would be arbitrage to make. In a theoretical example where the long-term interest rate is lower than the short-term interest rate, one can assume that this is a sign of an upcoming recession (Berk & DeMarzo, 2016). This statement is very interesting as the spread between the two interest rates decreased in magnitude in the years before the financial crisis and peaked in the middle of 2008 when the recession began. Today, the spread between the short-term and long-term interest rates looks better than before the financial crisis. However, it has decreased in magnitude in the last couple of years.

Figure 11: The Real Effective Interest Rates from 1992 until 2020

Note: Own creation based on Finans Danmark’s database Obligationsrenter

Another thing to notice is the decreasing trend over the years in the interest rate levels. They started rather high and then slowly converged downwards until 2005. For a few years, the interest rate increased until it peaked in 2009 as a consequence of the worldwide financial crisis. Since then, the interest rate has gone in only one direction, down. Currently, we see very low interest rates, where the long-term interest rate is below 2% and the short-term interest rate is below 0% (Finansdanmark.dk, 2020). The reason why the short-term interest rate is lower than the long-term interest rate is simple. A spread between the two

31 interest rates is required because investors take a higher risk when borrowing money with a fixed rate over 30 years than they do if they borrow it over a shorter period.

The short-term interest rate is also affected by the monetary policy that Denmark has. As Denmark has a fixed exchange rate that has to be pegged to the Euro, their monetary policy is completely determined by what the European Central Bank is doing (Nationalbanken.dk, 2018). Denmark has one goal and that is to keep the exchange rate fixed so that one Euro is equivalent to 7.46 krone with an allowed derivation of +/- 2.25%. Hence, the krone must be within the range of [7.30;7.63] krone per Euro. As Denmark has pegged their currency to the Euro an increase in the term European interest rate will affect the Danish short-term interest rate as well.

The effect of Covid-19 on Interest Rate

It is quite interesting how the coronavirus has affected Danish interest rates. In theory, when the economic world becomes volatile investors tend to buy bonds and sell stocks (Berk & DeMarzo, 2016). However, when the coronavirus began to impact the Danish economy significantly investors started to sell both stocks and bonds instead of selling stocks and buying bonds. This development was counterintuitive according to theory. This can clearly be seen in Figure 12 where four different mortgage bond rates are shown. In the period between 02/03/2020 and 02/04/2020 investors panicked and sold off their bonds for the mortgages, which made the average mortgage rate drop significantly. However, as quickly as the rate came down, it acquired traction once again and regained its strength.

Figure 12: The Change in Bond Rates During the Coronavirus Pandemic

Note: Nordea’s Interest and Rate Estimates (Nordea.dk, 2020)

32 This same trend can be seen when looking at the weekly nominal interest rate updates from Finans

Danmark. In week 11 of 2020 the long-term nominal interest rate was at 1.14%, in week 12 it was 1.46%, and in week 13 it was at 1.56%. It increased more in just three weeks than it decreased in over a year.

However, from week 14 onwards it has decreased slowly once again. The interest rate has clearly been affected by the COVID-19 virus. However, it was affected by COVID-19 for only a short period of time and by the end of the second quarter of 2020 the interest rate was back at the same level as before the virus started.