Rising mortgage rates will help cool housing market (and the AAA rating debate)

Christopher Joye

Coolabah Capital

In the AFR this weekend I write that over the years my column has been the staunchest possible defender of Australia’s prized AAA sovereign credit rating, regularly excoriating Standard & Poor’s for putting it on “negative outlook” ahead of a possible downgrade, only to belatedly normalise the rating years later to “stable” as the “wonder down-under” repeatedly bested its global peers. 

We’ve also jabbed S&P for daring to downgrade Australia’s banking industry country risk assessment (BICRA) score, which it is now finally considering restoring to its previous position alongside Canada and Singapore, which is where Australia should be situated today.

It should not, therefore, be surprising that a fickle S&P is yet again flirting with a full-blown downgrade from AAA to AA+ after skittishly making us the only AAA-rated nation that deserved a “negative outlook” back in April 2020.

It is well-known that S&P has always had an itchy trigger finger apropos Australia’s AAA rating, doubtless driven by the fact that the AA+ rated Americans cannot fathom how our little sunburnt country could be more creditworthy than the world’s mightiest military power (although old mate Xi is catching up fast).

S&P’s April 2020 decision to place the rating on negative outlook appears superficially muddle-headed juxtaposed against Australia’s world-beating COVID-19 and economic management, which has massively outperformed other AAA-rated nations care of the efforts of Team Australia, including the Commonwealth Treasury, the Reserve Bank of Australia, the Australian Prudential Regulation Authority and of course the politicians who ultimately make the big calls.

And yet CBA’s ballsy fixed-income strategist, Philip Brown, believes that following Treasurer Josh Frydenberg’s generous budget this week, a downgrade is definitely on the cards, concluding that “we think the rating remains on a very fine line, with a downgrade [to AA+] the more likely outcome”.

Brown is worth listening to and was conspicuous in picking the NSW government’s credit rating downgrade from AAA to AA+ in December last year alongside Victoria, which S&P shunted down even further down to AA.

While Australia has been the best AAA-rated manager of the coronavirus crisis, Brown asserts that the “government has spent essentially all the potential improvement in the deficit from higher revenue and lower expenditure on new stimulus”. “As revenues return to something fairly normal over the forward estimates, spending remains much higher than previous levels,” he says. “The 2024-25 spending is greater than the GFC peak, for example”.

Brown’s punchline is that “on a pure reading of the current budget numbers, the Australian sovereign is AA+, not AAA”.

He highlights that Australia’s net debt to GDP ratio is projected to continuously increase out to 2024-25, amplified by state government spending that has been egged on by the RBA. In fact, if Australia joins NSW and Victoria in losing its AAA rating, they can all blame the RBA for very aggressively jawboning them into running big deficits under the cover of its quantitative easing program, which the RBA promised would keep borrowing costs wafer thin.

“A consistently rising net debt to GDP ratio while already on negative outlook is not a recipe for retaining AAA in the long term,” Brown warns.

One caveat is that Treasurer Josh Frydenberg has once again employed exceptionally conservative forecasting assumptions, which all but guarantees that he will smash the budget’s official estimates as he and his predecessor have repeatedly done since 2017.

If that is the upside potential, the downside is that Australia’s economy now faces the most dangerous geopolitical environment in decades, exemplified by the one-sided trade war China is waging on all our exports save iron ore, which is bound to eventually move into Beijing’s cross-hairs.

For years I’ve argued that the Middle Kingdom is likely stockpiling iron ore in preparation for a potential major power conflict over Taiwan. This commodity is essential to produce steel, which is equally important for guns, bullets, naval vessels, tanks, shells, and all manner of military equipment.

With a consensus emerging that a serious conflict over Taiwan has become more likely (albeit that many hope that peace will still prevail), this presents a new threat to the AAA rating.

While a downgrade of the sovereign rating to AA+ would not impact State government ratings (except ACT, which would also fall to AA+), it would immediately translate into lower major bank credit ratings.

The major banks’ AA- senior bond ratings rely on the sovereign rating staying at AAA. A downgrade would see the majors’ senior ratings drop one notch to A+, which is still very high by global standards. On our modelling, this one notch move would cost the majors only about 10 basis points in extra annual interest in bond markets, which they have demonstrated they can easily recoup.

In fact, a modest increase in bank funding costs after the RBA’s term funding facility expires in June could be the perfect tonic to help cool the heated housing market ahead of the imposition of more draconian measures. In conjunction with the RBA’s 3-year yield target of 0.1 per cent, the RBA’s term funding facility (which allows banks to borrow north of $180 billion for 3-years at an incredibly low annual cost of 0.1 per cent) has been the key driver of the record low 3-year to 5-year fixed home loan rates. Whereas fixed-rate mortgages used to only account for about 15 per cent of all new home loans, that has leapt to around 40 per cent since the pandemic.

We have forecast for some time that fixed-rate home loan costs would have to start climbing, and the banks have obliged with many recently lifting these rates by 0.2 percentage points or more.

Once the term funding facility expires in June, we are projecting a big increase in traditional wholesale debt issuance by Aussie banks, which should be between $150 billion and $350 billion over the next few years. This will help normalise the banks’ cost of funding back to pre-coronavirus levels, which will incentivize them to push borrowing rates back up.

It could be a very elegant solution to the risk of excessive ebullience emerging in the housing market, which should nevertheless remain robust for years to come. Nobody should be fretting about a 50 to 100 basis point increase in the cheapest fixed-rate mortgage rates in history, which are almost 200 basis points below their January 2019 levels.

One silver lining for the major banks is that S&P has put Australia’s banking industry country risk assessment (BICRA) score on a positive outlook for a 1-in-3 probability of an upgrade over the next 2 years. If this occurs, the major’ senior bond ratings would bounce back up from A+ to AA-. This would also result in their Tier 2 ratings rising from BBB+ to A- while their hybrid ratings would increase from BBB- to BBB.

An upgrade in Australia’s BICRA score would also be a big deal for Bank of Queensland and Bendigo, which would have their senior bond ratings lift from BBB+ to A-, which is where they used to sit before S&P downgraded our BICRA score in 2017.

Since S&P has only just shifted the BICRA score to a positive outlook, a more plausible scenario is a sovereign rating downgrade in 2020 that cuts the major banks’ senior bond ratings, which then recover at some point in 2022 or 2023.

A final tailwind for bank funding costs is likely to be a regulatory requirement to hold more government bonds as their emergency liquid assets (in line with global best practice). In the past, the regulators have let the banks use senior bank bonds, AAA-rated residential mortgage-backed securities, and their own home loans as so-called liquid assets, which differed to the rest of the world. This exception was afforded to Australia because of the historically small size of our government bond market.

As government debt issuance has exploded because of record budget deficits, this exception is no longer defendable. One argument is that banks should be able to continue using their own senior bonds as liquid assets to keep their funding costs low in the face of a tsunami of new supply to pay back the term funding facility.

On the other hand, their total senior funding requirements are likely to remain lower than has been historically the case because of their much larger Tier 2 subordinated bond issuance, which has ramped up to meet APRA’s total loss-absorbing capacity targets. Some might also point to a structural increase in funding available via bank deposits because of a heightened focus on liquidity and risk-aversion since the pandemic.

All of these costs can be quickly recovered by repricing borrowing rates, which should assist in attenuating any excess demand in the Aussie housing market.  

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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 40 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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