Accurate CBA economist forecasts RBA ends hiking cycle at 1.25%, inducing a 10% decline in house prices as $500bn of fixed-rate loans expire in 2022/23...

Christopher Joye

Coolabah Capital

CBA's head of Australian economics, Gareth Aird, who has been arguably one of the most accurate economic forecasters in recent times, has just published a new research note projecting that the RBA will finish this hiking cycle at a cash rate of just 1.25%, which is materially below the RBA's estimate of neutral at circa 2.5%. Having said that, the RBA does not seem to have a high fidelity commitment vis-a-vis this 2.5% estimate. In a recent Q&A on 2 February, Governor Phil Lowe was asked:

What sort of consideration do you have to make about possibly running too late with pushing rates higher and then being forced into doing aggressive rate hikes when things get out of control and you're having to play catch up? 

And his response was very interesting---even surprising---explicitly suggesting that the potency of monetary policy might have risen as a result of the increase in debt across the economy, which implies that interest rates will not have to climb as far as they have in the past for a given targeted impact:

If we're wrong there and inflation does pick up and doesn't come down, then we will have to increase interest rates more quickly than I currently think is possible. And I think, this remains to be tested, that when interest rates go up this time, the household sector will be quite responsive to it. 

In another section of the Q&A, Governor Lowe repeated the same observation, noting that "the household sector has a lot of debt so I think they'd be quite responsive to an increase in interest rates". He's evidently hinting at the possibility of a regime change with respect to the neutral rate.

This reconciles with our own research (see here) replicating the RBA's complex model of the housing market, which finds that a 100 basis point increase in mortgage rates would reduce house prices by 33%. This model has done a good job of explaining past house price changes.  Coolabah's forecast is for a 15-25% fall in house prices after the first 100bps of hikes. Other prominent forecasters have followed suit since we published our own predictions in October last year, with Westpac now calling for a 14% decline in prices and CBA and NAB expecting a 10% correction. 

Lowe's remarks also reconcile with CBA's call for a terminal RBA cash rate of just 1.25%. If there is one thing that CBA understands pretty well as the nation's largest residential mortgage lender, it is the Aussie housing market. In the new research piece, CBA's Gareth Aird comments:

We expect one further 25bp rate hike in Q1 23 that takes the cash rate to 1.25% ‑ our estimate of the neutral cash rate. At this stage we do not anticipate that the RBA will need to take monetary policy to a contractionary setting.
The economy is not static. Interest rate increases will generate changes in behaviour, which in turn will impact economic outcomes. For context, we estimate there are over one million home borrowers who have never experienced an increase in mortgage rates.
The RBA will need to assess the impact of rate hikes on the economy, particular the household sector and the housing market, as they move through the tightening cycle. This means the central bank is likely to be patient and a gradual and shallow rate hike trajectory is our base case.
We expect the RBA to stop their tightening cycle in early 2023 when the cash rate hits 1.25%. At that point the annual rate of wages growth should be comfortably above 3%. But this does not mean that the RBA will continue to raise rates. Indeed we believe they will not need to.

The key to CBA's view is really the impact of rate increases on the housing market, and, more specifically, that there are going to be half a trillion dollars of fixed-rate mortgages expiring over the next 2 years (with a peak in 2023) that will likely be hit with a large, possibly 75-125bps increase in their repayments as these loans roll-off and are replaced with new variable rate products (most of the new flow of home loans has recently switched from fixed-rate back to variable-rate as banks have massively increased fixed-rate prices). Aird explains: 

The fixed rate home loan expiry schedule means that over the next two years a very significant proportion of home loans will expire (see chart opposite for the CBA fixed rate loan book expiry profile). Based on CBA’s fixed rate home loan expiry schedule and share of the market there is likely to be around $A500bn of fixed rate mortgage loans expiring in Australia over the next two years.
We estimate the average loan rate of the fixed rate mortgages currently in the system sits between 2.25% and 2.5%. This rate is expected to be significantly lower than both the standard variable rate and fixed rates over H2 22 and 2023. As a result, borrowers rolling off fixed rates will be refinancing their loans at a materially higher interest rate, which will have a significant impact on the interest cost of debt and household finances.
The peak expiry of fixed rate home loans occurs through 2023. This means that a natural tightening in financial conditions will happen through 2023 even if the RBA remains on hold following its final anticipated rate hike in Q1 23.
The economy is also expected to deal with the headwind of an orderly correction in home prices in 2023. Our forecast is for a 10% decline in national dwelling prices over 2023 as higher interest rates weigh on the demand for credit.
In summary there will be a variety of forces at work on the Australian economy in 2023 that will exert a cooling effect on demand, which in turn will alleviate inflation pressures. We therefore do not agree with market pricing that the RBA will continue to hike the cash rate throughout 2023. 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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