Welcome to Finance and Fury – In this episode, we will be looking at the future of property prices based around recent changes in lending assessment, bond yields and what this means for interest rates

  1. It comes as no surprise when I say that property prices have gone up a lot over the past 2 years – well above forecasts – at the same time, and in a causal manner, interest rates and bond yields have declined to record lows – but is the party coming to an end sooner than expected? As there are some emergences in the bond markets which may spell an interest rate increase ahead of schedule – putting downwards pressure on property prices –
  2. There is a bit to unpack here – do so in three parts – we will go through the current state of the property market – then what happened last week in the bond market in Australia – then what this means for central bank policy on interest rates

 

To start with – Looking at housing prices – Almost in lockstep – prices have increased at rapid rates across the world, reaching new heights in many cities –

  1. But rural and urban markets have shared in the spoils – which is noteworthy for two reasons
    1. First – lockdowns and movement restrictions have given rise for remote working – which has actually weakened the case for urban housing – but yet prices in urban areas continued to rise
    2. Second – housing affordability in cities was already heavily strained even before the latest irrational exuberance in property took hold – yet the lack of affordability of homeownership for large parts of the population has evidently not been an obstacle to price increases
  2. Why is this the case? Record low financing costs have increased borrowing capacity for property buyers –
    1. Plus – there is an entrenched expectation that most people hold when it comes to property in Australia – that is of long-term value gains which has made owning a home so appealing that the price level doesn’t seem to matter – FOMO – it can be hard to wait to buy, if you think that in doing so the prices will be 10% higher next year, as this is what you are used to seeing
    2. These higher prices have led to higher household leverage levels – as the current acceleration in mortgage volumes clearly demonstrates – Data from CBA shows that across the country, the new average mortgage across the whole of Aus (higher in Syd and Melb, lower in NT) stands at $580,900 – which is up by around 16%, or $80,000 over the past 12 months – is it any wonder why prices have gone up by so much?
      1. This has exacerbated worsening affordability, unsustainable mortgage lending practices, and a rising divergence between prices, household incomes and rents – all of which have historically served as forerunners of a housing crises
      2. But as long as financing costs trend toward zero, property prices, incomes, and rents can continue to decouple from the real ability of borrowers to cover these debts
    3. These have been trends just not seen in Australia, but worldwide – As a result, the growth of outstanding mortgages has accelerated almost everywhere in the last 12 to 18 months, and debt-to-income ratios have risen—most markedly in Canada, Hong Kong, and Australia
      1. Due to this – pressure is mounting on governments and central banks to take action – even before lockdowns – Lending standards were being relaxed due to ever declining interest rates over the past decade – Overall, housing markets have become even more dependent on very low interest rates, meaning a tightening of lending standards could bring price appreciation to an abrupt halt in most markets
      2. New entrants into the property market have to borrow increasingly large amounts of money to keep up with higher prices – or even people wishing to upsize to a new property – As a result, the growth of outstanding mortgages has been growing due to the relaxed lending standards and falling mortgage rates.
    4. Therefore – ever-higher property prices and leverage levels imply ever-higher risks due to the property market being under the spell of a dangerous narrative – that the party will keep going
      1. The main barriers for borrowing that most households face is now based around creditworthiness – i.e. how much people can borrow – so once that obstacle is cleared, coupled with the expectation of ever-growing house prices – this has exacerbated the FOMO making homeownership look attractive regardless of price levels and leverage that it costs
      2. This rationale may keep markets running for the time being – whilst interest rates are low – But it’s not sustainable in the long run. Households have to borrow increasingly large amounts of money to keep up with higher prices – resulting in higher levels of principal repayment each month – on top of the risk that interest rates rise
    5. Does all of this mean we are in a bubble? – looking at a paper released by UBS on the Global Real Estate Bubble Index – Price bubbles are a recurring phenomenon in property markets across the world – but the term bubble is a little tricky
      1. The term “bubble” refers to a substantial and sustained mispricing of an asset, the existence of which cannot be proved unless it bursts – this is because all because the price of something increases massively, to almost unsustainable levels – it doesn’t mean that it is a bubble – because ironically it is only a bubble if it pops – if rates stay near zero, or even go negative and stay there, property prices can continue to climb
      2. But historical data reveals a pattern that exists with a bubble in the property market – the most typical sign is that of a decoupling of prices from local incomes and rents, as well as occurring at the same time as imbalances in the real economy, such as excessive lending and construction activity
        1. But again – even prices in Sydney are not considered to be in a bubble unless there is a turnaround in interest rates – otherwise the decade-long upward trend of house prices is likely to continue, given ongoing population growth
        2. But there are some risks to the property market now emerging – coming from APRA and the RBA

Over the past month – APRA has started trying to reduce lending risks – directing banks to tighten up their assessment

  1. Price growth has clearly outpaced local incomes, stretching affordability and thereby increasing dependence on easy financing conditions even further. The growth of outstanding mortgages is accelerating again, as households are taking advantage of historically low interest rates – even people who own property are refinancing to make renovations on their existing property – Therefore – A tightening of lending rules would likely result in a setback for prices.
    1. It is now recommended by APRA that banks increase their ‘buffer’ from 2.5% to 3.0% on top of their loan serviceability rate
      1. This is the assessment that banks take when you apply for a loan – they look at what you could afford based around this serviceability rate, not the current interest rates
    2. However – Only two years ago, APRA’s loan serviceability floor was set at 7.25% – this was more or less a hard fix – but at interest rates dropped, pressure built to change the rules which took force in 2019 –
    3. Today – On a 1.99% home loan, a borrower would be assessed on their ability to repay the mortgage at an interest rate of 4.99% – the interest rate plus the new APRA buffer of 3.0% 
      1. In reality – serviceability rates are also often calculated on standard variable rates, which are higher than discounted rates that most banks offer – but it is still lower than 7.25%  
    4. This change is expected to reduce the borrowing power of property buyers by around 5%
      1. Therefore, using some simple maths – each 0.5% of serviceability rate equates to 5% of borrowing capacity – As an example, someone who could borrow $1 million under the old buffer could now only borrow about $950,000 – but now compare this to the rules prior to 2019 – if the serviceability rate was 7.25% compared to say a standard variable rate of 5.5% (2.5% standard rate plus 3%) – this is 17.5% more that people could still borrow, even after the tightening of the lending rules
      2. While the banking system is well capitalised due to their ability to bail in with equity or capital notes – increases in the share of heavily indebted borrowers, and leverage in the household sector more broadly, mean that medium-term risks to financial stability are building
    5. The expectation is that housing credit growth will run ahead of household income growth in the period ahead – this means that more tightening could come to help curb the level of leverage – where the buffer rates increases to 3.5% and beyond
      1. What is interesting, is that these moves from APRA came after a recent RBA’s post meeting statement flagged the importance of loan serviceability buffers –
    6. Which brings us nicely to the new development with the RBA –

Looking at The RBA – have said they will keep interest rates on hold until 2024 – giving forward guidance to the market, that rates will be on hold until at least until this time – to achieve this in practical terms through monetary policy, the RBA has been helping the bond markets through market operations, purchasing bonds of the secondary market to keep yields at their current target rate for 3 years at 0.1% – by any other name this is called QE

  1. But going back to Thursday last week – Or on the 28th of October depending on when you are listening – The RBA made no offer to buy the next trance of government bonds – they declined to buy the April 2024 line of bonds as part of their regular market operation, even though the yields of these bonds were already above their target of 0.1%, sitting at 0.16% – This created a shock to the market – Central banks had given clear guidance that they would do whatever it took to keep the yields of these bonds in line with the cash rate – but all of a sudden, they reneged on their agreement with not a peep
    1. As expected – the market responded poorly – by dumping these bonds, resulting in the price dropping and pushing the yield up further to 0.30% –
    2. The market waited to see if this was just a blunder – or if they were waiting until Friday – Friday came and no purchase were made – so more of these bonds were sold off and the yields spiked even higher to 0.67%
      1. Remember that a yield is the % return based around the price of the bond
    3. The fact that the RBA out of the blue decided to not purchase these bonds, which are a core part of their stimulus programme – started stoking market speculation that there is going to be an early hike in interest rates than previously thought
      1. This failure to deliver on what the RBA has promise has fuelled markets expectations that rates will have to rise much earlier than 2024 – based around the current pricing – it appears that the consensus is that there will be a 50 basis points of tightening by mid next year, and 100 basis points by year end – so interest rates will be around 1% by the end of 2022 – rather than being 0.1%
    4. Offshore events added to the drama and probability that this may occur – with the Bank of Canada stunning markets on Wednesday by ending its bond buying altogether and flagging a hike as soon as April 2022. We also had many Central banks, including is New Zealand raising the reserve cash rate by 0.25%
    5. The RBA is now under intense pressure to do something at its monthly policy meeting at the start of next month – where they will either defend its yield curve target, soften it, or drop it altogether.
      1. The RBA currently aims to buy A$4 billion a week in bonds as part of QE programme – This was always going to be reconsidered in February 2022 – But this recent unexpected withdrawal from purchasing bonds could signal the end to this plan sooner rather than later
      2. This action signals that the first-rate hike back to 0.25% could occur sooner than later, compared to 2024 – followed by four more moves to 1.25% by the third quarter of 2024
      3. Overall – if any increases in interest rates occur, then it can be expected that these will be shallow and gradual based around a tightening cycle – it is unlikely that the RBA will increase interest rates to 1.25% in one go next year – given the elevated level of household indebtedness
    6. But this increase in interest rates ahead of schedule does put a potential downwards pressure on property prices
      1. Given that an increase by 0.5% in serviceability rate creates a reduction of 5% in borrowing standards – an increase to 1.25% for the interest rate results in around 12.5% less borrowing capacity – which means that the part may be over for ever increasing property prices – as people can borrow less and the costs to borrow become more stark
      2. but on top of this, an increase in servicing costs – If the average mortgage is $580,900 – then an increase of 1.25% results in an additional $7,261.25 p.a. in interest repayments – there are around 10.3m properties in Aus, and around 6m of these have a mortgage attached to them for which this average is based around – doing some rounding, that means that an additional $43.6bn will be spent on interest costs of owning a property
      3. This takes funds away from other spending in the economy and puts a downwards pressure on GDP spending

Summary –

  1. Property in Australia is being spurred by interest rates, no surprise here – due to the increasing amounts that people can borrow, increasing the capital available to big her amounts on property – it is supply and demand
  2. If the RBA fails to follow through with their commitments to keep the 2-year bond yields at 0.1%, instead letting this spike to closer to the free market rate of 0.67% due to not purchasing these bonds – This could mean that an interest rate increase is likely to happen sooner rather than later –
  3. If increases in rates occur before is anticipated, this will have major impacts on the market –
    1. Servicing costs of households will increase
    2. From an Asset pricing perspective – prices of property could decline – or at the best reach a stagnant growth until wages and immigration rates catch up
    3. The market is currently addicted to almost free money – needs this to continue for price growth to continue, if not the prices of assets would come back in line with the fair value that interest rates represent
      1. The current price of property is technically a fair value based around record low interest rates – if interest rates go up, then the fair prices, or market price, would go down for property – if rates go negative, then prices can continue to grow
    4. Will the increase of rates and the decline in property be this week – probably not – but can we trust when the RBA has been telling us? No – the forward guidance has been that they won’t increase rates until 2024 – either they will do this on the exact day these bonds mature – in April – or there is a chance that this occurs ahead of time –
    5. Either way – this is a warning – for those new home buyers – if you are purchasing for the first time – make sure you can afford repayments at a buffer of 1 to 2% interest rate above your current margin
      1. If these market predictions come true, it would dampen the potential price growth that property has been going through – so don’t be banking of some short-term capital growth from a property purchase – to purchase now and be able to accumulate equity quickly to upscale
        1. Based around the rough numbers from CBA – borrowing declines by 5% per 0.5% in interest rates – so prices have the potential to decline – putting pressures in LVRs
      2. For existing buyers as well – same thing applies – make sure your cashflow can afford the interest repayments – if anything, this is an opportunity to get ahead of mortgage repayments before the interest rate cycle reverses

Thank you for listening to today’s episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

https://www.ubs.com/global/en/wealth-management/insights/2021/global-real-estate-bubble-index.html

https://tradingeconomics.com/australia/2-year-note-yield

 

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