The future state of the housing market.

Welcome to Finance and Fury. Current state of the housing market – and the influence The RBA has and will have on Housing prices.

The RBA has a long history of influencing the Australian housing market due to their control over the cash rate – for the past 30+ years – these changes have dramatically influenced property prices, leading to affordability issues for which the RBA seems to not care – but this shouldn’t come as a surprise – they have no mandate to focus on property prices when making their monetary policy decisions –

1. House price changes and affordability issues plays no role in whether they make a decision to increase or decrease interest rates – instead, inflation (CPI), unemployment and GDP are at front and centre of these decisions
   1. When inflation is low and GDP growth slowing, then the RBA is likely to cut rates – this then has a secondary effect to push up property prices – which when looking at the historical data can be easily seen
   2. And for the better part of the past 30 years – we have only been on a downwards trend in interest rates – this interest rate cycle has heavily influenced house prices – which have never been more inflated than they are today after years of artificially cheap money
2. This puts the Australian economy at risk – the average Australian is heavily debt burdened – increasing the sensitivity to interest rate hikes – which are currently underway
   1. Looking at some of the data – Australia’s household debt-to-income ratio is sitting around 186% – being at an all-time high – the level of debt to Income has increased massively over the last 30 to 40 years – being under 60% in the late 1980s
   2. Household debt to GDP – 120% – up from 30% in the early 1980s
3. These increases in credit to standard measures of the economy – being economic output and incomes is due to a combination of two factors – declining interest rates and changes to banking regulations
   1. Banks no longer work off a fractal reserve system – since the early 90s – there has been no limit on lending as the tier 1 capital in a bank could be increased to meet the demand for lending – without increasing interest rates – previously they would need consumers to deposit funds into a bank account and then use these are reserves to lend additional funds – so if people weren’t saving, banks couldn’t grow credit – today, banks can lend however much they want and at the end of the quarter – if they are over their RWA ratios – they simply issue more capital notes and problem solved
   2. On top of this – we have the changes in the servicing calculations which allowed borrowing capacities to increase
      1. Add these factors onto the declining interbank cash rate and you have a massive boom in credit growth – translating into property price growth – as household debt growth leads to house price growth
   3. This has all set the stage to where levels of debts have boomed – but this has left consumers and therefore the economy at risk of increasing rates
      1. These debt risks will be exacerbated by the first round of hundreds of billions of dollars of cheap fixed-rate loans transitioning to much more costly variable rates within the next two years
      2. If you fixed a rate 12 months ago at 1.95% – then in another 12 months this may cost you 3.5% or 4% on a variable loan – amplifying the impact of interest rate increases
   4. The RBA has a history of affecting property prices – Their forward guidance was also affecting behaviours – as many home buyers have capitalised into house prices based on the assumption that rates would remain low-for-long – as even the RBA commitment to not raise interest rates until 2024 – which has obviously been discarded
      1. if their job was to help with stable property price growth that match affordability, then the results that have been seen over the past 2 years would be a massive blunder – but as it is not, property price movements are simply a second order consequence – which is important to keep in mind – as the incoming increases will likely negatively affect prices – so it begs the question if the RBA will take into account the price decline at all and if this will start to impact their decisions to ease up on rate increases
   5. To explain this – first we need to look at what happens if the credit growth dries up due to increasing interest rates – or even shrinks of people default on mortgages?
      1. The RBA have estimated that property prices increase by around 14 to 17% for every 1% drop in the RBA cash rate – so does this mean that property prices act in reverse, where a 1% increase could mean a 17% drop in prices?
      2. I don’t think so – due to the difference is behaviours of buyers and sellers – buyers generally want to purchase a property at a greater demand than what a seller wants to get out of the market for good
         1. A portion of buyers are doing so for the first time – and want to purchase if they can afford to do so, even at record prices – and they can afford to do so due to the banks lending them the money
         2. People can stop buying – but if existing owners aren’t selling – it simply slows the market down – where demand and supply meet

• Plus, Due to the nature of property being illiquid, prices tend to decline at a slower pace than financial markets, like shares or bonds

7. How does this compare to the historical data – looking at CoreLogic’s data for this – Looking back to 2006 –
   4. Up until the most recent hike, there has been one hike since 2006, in 2010 – how did markets respond – negatively – prices dropped over 18 months until recovering due to a rate cut at the end of 2011 – then between 2011 and 2017 the RBA dropped its cash rate from 4.75% to 1.50% – Over this time, national prices soared an amazing 41% across the whole country based on CoreLogic’s data – this was 48% in just the major cities  
   5. Over this time – the other things that negatively affected prices were the APRA regulations – Between 2015 and 2017 – APRA’s limits on credit creation forced lenders to materially jack-up interest rates on investment property loans – Between 2017 and 2019, the 8-capital city index price slumped 10.2% – there was nothing else in the economy going on except the drop in credit growth – which saw the biggest fall in house prices since the early 1980s when rates were last materially increased
   6. Then in mid-2019 – the RBA rate cut drove house prices up 10.3% over the next 12 months – and by October 2021, the all regions dwelling value index had increased by 20%
8. Now with rates going from all-time lows – there are forecasts of a record housing downturn
   1. The general consensus of forecast is that national home values would correct by 10%-25% after the first 100 basis points (bps) of RBA cash rate increases between now and 2024 – this would represent a record draw-down in Aussie households’ most valuable asset.
   2. It’s worth putting this in context – as even after a maximum 25% decline home values would still by up 12% since mid-2019 – when the RBA first started cutting its cash rate from 150bps down to the 10bps level
   3. However – There is no precedent for the RBA hiking through a period in which house prices are falling materially – which we are entering into

So some increases in rates are on the cards – and prices of property may suffer in kind – but why might the RBA pause rate hikes?

1. The course of action for the RBA – they will increase rates to a point – then pause the increase due to negative economic news –
   1. The best guess is that the RBA will pause its monetary policy tightening process after the first 100-150bps of cash rate hikes – over this increase, it is possible that banks will pass on more than the full amount and housing prices will fall further due to this
      1. The precise size of the additional out-of-cycle hikes we will see from banks is not known – but due to the expiration of the fixed funding costs they have been able to access expiring, their funding costs are going to soar – if you have been paying attention you would have seen the major banks reprice the fixed interest rates – where a 3-year term fixed-rate home loan has gone from 1.98% 12 months ago to 4.5% today
   2. So – Given the total value of residential real estate in Australia is estimated to be worth $10 trillion – a 15% drop in property prices would see a $1.5 trillion draw-down in national home values – which if you believe in the wealth effect would start to impact spending –
   3. But lets say the wealth effect doesn’t exist – where people spend more when they feel rich – a large chunk of the population wont be able to spend more due to having higher costs of housing –
      1. As this increase in costs of interests will materialise in less being spent in the economy – if the average mortgage is over $600k – then a 1% increase would result in $6k less per household in expenditure capacity – if there are 10m mortgages – this results in $60bn less being able to be spent every year – as consumption is the majority of our GDP – this could translate into a 4% drop in GDP – also assuming there is no multiplier effects
   4. Now – all of these are forecast based – and no forecast is ever accurate – even the RBA’s governor Phil Lowe noted that they have had some embarrassing forecast misses
      1. Lets look at the start of 2020 – where the RBA and banks were forecasting a big house price decline of around 20% in property values – these forecasts were shattered due to the drop in interest rates
         1. Though, everything else being equal and keeping rates where they were – prices could have dropped
      2. CoreLogic’s all regions price index fell 2.1% between March and September 2020 – a far cry from 20% – but then started climbing quickly again
      3. When the RBA dropped rates – they claimed that there would not be a housing boom in response to its policies because population growth was non-existent – and how could you have property price growth without a growing population
      4. From the RBA – they have recently released one model called the Saunders-Tulip model – this was released in the latest Financial Stability Review – in this the RBA remarked: “Estimates using a model of the housing market that takes into account historical relationships between interest rates and both demand and supply factors suggest that a 200 basis point increase in interest rates from current levels would lower real housing prices by around 15 per cent over a two-year period, relative to the baseline model projection in the absence of an interest rate shock.”
   5. The RBA may increase rates by 200bp – or 2% – but with a slowing economy – from less economic spending from households due to increased servicing costs in debt – they may need to reverse course
   6. What are some positives for the property market – things that can mitigate the projected price declines
      1. Wage growth is expected to recover – so if the RBA is gradual with its rate increases where they spread this over the next 3 to 4 years – then any correction in property can be offset by increases in incomes – but this is unlikely to do much when considering the increases in rates are estimated to occur in the next 18 months before real wage growth can help to offset this
      2. In addition – the RBA has zero interest in triggering a recession or a downturn in economic growth that would deny workers their jobs and the healthy wage growth that the RBA has been trying to stimulate – if spending slumps in response to increases in rates – then they will need to revisit their policy and adjust to pause or reserve trend in rate increases

Summary

1. Some property price corrections are likely – inevitable based around historical trends – when rates drop, prices go up, and when rates increase, prices drop – nothing getting around this truth –
2. Should be aware that there is a high chance we see a correction of around 15% in prices over the next two years – but that is the nature of every cycle – the most important thing is to not panic and be in a position where you loan is affordable – if you are buying for the first time – make sure that the interest repayments are affordable based around a 4% interest rate – or even 5%
3. Plan in advance around your budget – are there discretionary expenses that have crept into your spending habits over the last two years as rates have dropped? Can these be cut out and better used to repay debts, or cover the increase in interest expenses?
4. Whilst you have no control over property prices – you can control your responses – so plan and act accordingly.