Aussie house prices could fall more than 30 per cent

Christopher Joye

Coolabah Capital

In the AFR I write that Aussie house prices could fall by more than 30 per cent if the Reserve Bank of Australia’s fulfils uber-aggressive market expectations for an increase in its cash rate from the post-pandemic nadir of 0.10 per cent all the way to 4.25 per cent. This would translate into an increase in the cheapest discounted variable mortgage rate from around 2.25 per cent to 6.50 per cent, or possibly higher given bank credit spreads (or funding costs) have widened sharply.

This newly published research represents an effort to further refine our Australian house price forecasts, which since October 2021 have anticipated a 15-25 per cent decline in dwelling values if the RBA lifts rates by more than 100 basis points.

The analysis, which has been undertaken by our chief macro strategist, Kieran Davies, refines and extends the modelling off Trent Saunders and Peter Tulip in their sophisticated account of the housing market, which factors in changes in both demand and supply.

We previously used a refined version of the Saunders-Tulip (ST) model to examine the impact of a permanent 100 basis point increase in borrowing rates, which pointed to a large draw-down in national dwelling values of approximately 33 per cent. We adjusted this estimate down to 15-25 per cent using our own fundamental analysis. After publishing these findings in October 2021, almost all banks have revised their own housing projections in line with our lower bound, which is arguably the most bearish bank forecasters have ever been.

After publicly ignoring the ST model for years, the RBA adopted it in its latest Financial Stability Review for stress-testing purposes. In this work, the RBA looked at a temporary 200 basis point shock to borrowing rates, which reduced real house prices by roughly 15 per cent.

Kieran Davies has taken this one step further by flexing the ST model to emulate marketing pricing for the direction of the RBA’s cash rate. He assumes the cash rate climbs to a peak of 4.25 per cent in 2023 following which it falls to 3.75 per cent in 2025.

Adopting this profile for interest rates generates a materially more severe peak-to-trough draw-down for Aussie house prices of about 40 per cent. This is substantially worse than the experience of the US housing market during the sub-prime crisis, which fell 27 per cent according to the Case-Shiller Index. It would also wipe out all the gains in Aussie home values since about 2014 using CoreLogic data.

While there are several limitations associated with this research, a key one is that it does not account for negative feedbacks from the housing market to the broader economy and hence monetary policy.

What we do know is that house prices in Sydney and Melbourne are now in free-fall, declining by about 1 percentage point per month. Other markets, such as Brisbane, Canberra, and Perth, have also started to roll-over.

Given the dramatic rise in the interest rate sensitivity and debt levels of households, there is a case for the central bank to carefully evaluate shifts in behaviour in response to tighter policy.

At this juncture, the RBA does not seem concerned about the consequences of policy overreach, and—based on Governor Phil Lowe’s public remarks—it wants to quickly lift its cash rate back to 2.5 per cent. It presumably believes it can do this without materially adversely impacting the economy. This would mean raising the cheapest discounted variable mortgage rates up to around 5 per cent.

This column’s view is that a record, 15-25 per cent decline in Aussie house prices, coupled with rapidly shrinking superannuation balances, will persuade the RBA that there is merit in pausing its hiking cycle to assess the impact of these changes on household behaviour.

The profound changes reshaping the asset-allocation landscape are truly breathtaking. If term deposits are paying interest rates north of 3 per cent annually and the risk-free, 10-year Commonwealth government bond offers a yield over 4.1 per cent, how does one buy a risky commercial property yielding only 3.5 per cent or 4.5 per cent annually?

Along these lines, why would you buy a residential investment property yielding 3 or 4 per cent (before transaction costs, depreciation, and other fees)?

If a BBB rated, Macquarie Bank bond offers a yield to maturity of 7 per cent annually, why would you buy Macquarie Bank shares yielding 4.4 per cent (including franking credits)?

The same question applies to the major banks. Why buy CBA equities yielding only 5.9 per cent (including franking) when you can buy a BBB+ rated CBA subordinated bond paying a fixed yield of 5.9 per cent with much lower downside risk? Or a higher-ranking and much lower volatility (relative to CBA equities) hybrid issued by CBA that provides a yield to its expected call (or repayment) date of 7.9 per cent?

For years we talked about the "search-for-yield" dynamic. That is, how central banks were flooring their interest rates to zero to encourage mums and dads to go out and punt on speculative investments in a search for higher returns. As cash rates soar, and the risk-free return jumps to 3-4 per cent, we believe the search for yield will be replaced by the “search for security” (and liquidity). This will require all asset prices to adjust downwards materially, as we repeatedly warned in December and January last year. We particularly called out equities, credit, bonds and crypto.

The S&P500 has declined by 24 per cent thus far while the Nasdaq is off 34 per cent (our forecast was for the S&P500 to decline by 30 per cent plus). Bitcoin has slumped 71 per cent from its 2021 peak and is on track to draw-down something similar to the 83 per cent loss in it incurred in 2018 (putting a target of around US$11,000).

Australian super funds have been massively overweight equities and underweight cash and bonds, in their asset-allocation, for years partly because the risk premium offered by equities was substantially higher than the returns afforded on comparatively low risk, or riskless, assets. That is no longer the case. In fact, most assets look like terrible bets compared to cash and low risk bonds right now.

One point that virtually all investors appear to have forgotten is that cash and floating-rate debt are your best possible hedge against inflation if you have a staunch inflation-fighting central bank that is committed to using its cash rate to combat price pressures, as the US Federal Reserve and the RBA appear to be. Recall that the RBA’s target cash rate was an incredible 17 per cent in January 1990!

This is not to say bond markets are impervious to the asset-pricing adjustments. The benchmark fixed-rate AusBond Composite Bond Index has lost a record 14.1 per cent since its peak in August 2021. This is because the yield on the fixed-rate bonds in the index has jumped from a low around 0.7 per cent last year to an astonishing 4.1 per cent today.

Floating-rate notes, which directly benefit from a higher RBA cash rate as the income they pay rises, have not been spared either. While the quarterly bank bill swap rate has jumped from 0.01 per cent last year to circa 1.70 per cent right now, materially improving FRN yields, the credit spread that an FRN pays above this base rate has also climbed sharply.

If we take the example of major bank hybrids, they have lost more than 3 per cent of their value in May 2022 as their credit spread above the bank bill swap rate has leapt from around 2 per cent in December 2021 to 3.6 per cent today. This means that a 5-year major bank hybrid paying a running yield of 2.01 per cent in 2021 has seen that lift to 5.3 per cent today. Of course, investors are trading off current valuations against higher future income returns. 

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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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