The RBA’s Dilemma: How house prices could limit rate hikes
In response to the rapid, ongoing rise in inflation, global central banks have embarked on policy tightening at an unprecedented pace. Indeed, market pricing for the Australian cash rate suggests that by the end of 2023 it will reach levels last seen in the late-2000s (see Figure 1).
The Reserve Bank of Australia (RBA) has the unenviable task of tightening policy enough to subdue inflation without setting off a correction in asset prices that could lead to financial stability risk. The RBA will be closely watching the housing sector, a key transmission channel for monetary policy. Higher interest rates are likely to lead to a reduction in household consumption due to rising mortgage servicing costs and negative wealth effects from falling house prices, as well as a slowdown in housing construction and renovation due to tighter credit conditions and lower income and employment within the construction sector.
House prices rose rapidly during 2020–2021 when the RBA cut interest rates in response to the COVID pandemic. They have started to fall in recent months, but given the lag in rate rises being passed on to consumers, we expect further declines in the coming year as housing affordability deteriorates.
We analysed how large a house price correction the RBA would be willing to tolerate before the risk of financial instability becomes more important than targeting inflation. In our view, the RBA would allow a house price correction of 15%–20%, but anything greater would pose too great a risk to the stability of the Australian banking system and the broader economy.
Stress testing the Australian banking system
For the purposes of this analysis, we define financial stability risk as the possibility of a negative systemic shock to financial institutions, markets or market infrastructures that prevents the smooth flow of funds between savers and investors. To assess the point at which financial stability would become threatened, we stress tested the four domestic systemically important banks (D-SIBs) to derive an estimate for the asset price fall required to cause their Common Equity Tier 1 (CET1) capital levels to drop below the regulatory minimum requirement stipulated by the Australian Prudential Regulation Authority (APRA).
We assessed two scenarios for peak-to-trough housing price falls (of 20% and 30%), comparing the results with the RBA’s “severe” scenario outlined in its Financial Stability Report (see Figure 2). To determine the impact of a worst-case scenario, we assumed that all the credit loss would be incurred and recognised in financial year 2023. In reality, asset impairment would likely take place over several years and banks would gradually recognize these losses. Therefore, the impact on their earnings, capital and non-performing loans (NPLs) could be more moderate.
In Scenario 1, we estimate that NPLs would rise to 4% and CET1 would fall by approximately 152 basis points (bps) to 10.3%, remaining just above the APRA CET1 requirement of 10.25% as shown in Figure 3.
In Scenario 2, our stress test analyses the effect of a more severe fall in GDP and a materially higher peak in the unemployment rate, which would lead to property price falls of 30% from their peak. We assumed that the countercyclical capital buffer applied by APRA for D-SIBs would no longer be required given the economic circumstances. Under this more severe scenario, we estimate that NPLs would peak at just under 6% and CET1 would drop to 8.2%, below APRA’s minimum requirement of 9.25%.
House prices could limit the RBA’s ability to increase interest rates
In our view, the Australian banking system is reasonably resilient, given its ability to withstand a 20% house price correction. This can be attributed to banks’ higher levels of capital and liquidity provisioning in response to regulatory changes following the 2008 global financial crisis. In addition, households have increased their savings buffers and many are ahead on their mortgage repayments. However, interest rate rises could begin to pose a risk to the economy and limit the RBA’s ability to hike rates further.
When underwriting mortgages, Australian banks are required to incorporate a serviceability buffer. Banks cap a borrower’s maximum loan amount based on an assessment of whether they would be able to repay their loans if rates were to rise by 2.5%-3% from the original interest rate. However, the market is currently pricing for mortgage rates to increase almost 4% from the COVID-related trough in the cash rate. Borrower default risk could increase significantly should this level of interest rates be realised.
The RBA estimates that a 20% fall in house prices would take the share of loan balances that are in negative equity to 2.5%, just above the pre-pandemic level of 2.25%. But if property prices fall further, we believe this ratio could increase exponentially. Indeed, our analysis shows that the banks’ CET1 ratio would fall to an unacceptable level upon house price falls of 30%.
Another factor that the RBA will need to consider is the more vulnerable cohort of borrowers that took on fixed-rate mortgages at very low levels in 2020-2021. During 2021, housing loan approvals soared by 51% year-over-year (yoy) to AUD 370 billion (see Figure 5), and we believe the 2021 vintage represents approximately 9% of the banks’ total loan book.
These borrowers will be exposed to significantly higher mortgage servicing costs once their fixed terms expire in 2023-2024 and their loans are reset at much higher rates (see Figure 6). This cohort also has a higher proportion of first-home buyers and borrowers with lower savings buffers and higher loan-to-value ratios. The delayed impact of RBA rate hikes on these borrowers adds an additional lag to monetary policy, which will further complicate the RBA’s decision-making and may increase the risk of overtightening resulting in a more severe house price correction.
What does this mean for investors?
In our view, the RBA will be forced to walk a tightrope between maintaining credibility around its inflation target and ensuring financial stability. This is likely to constrain it in raising the cash rate beyond the 3.50-4.00% range we currently expect. Should house prices start to fall more than 20% from their peak, it would introduce significant and potentially exponential risk to the banking system and the broader economy.
Nevertheless, with the cash rate currently 2.85%(1) (barely above PIMCO’s “New Neutral”), we believe the RBA will need to adjust policy well into restrictive territory in order to ensure inflation returns towards target and inflationary expectations do not de-anchor.
While Australian financials are demonstrating resilience, current valuations do not appear compelling compared with global and regional peers, such as U.S. and Japanese banks. Based on our stress test results and the recent letter released by APRA regarding the expectations on capital calls, we favour senior bonds issued by the Australian banks compared with Tier 2 and Additional Tier 1 bonds that sit lower in the capital structure.
For more on the outlook for the economy and markets globally, please read our latest Cyclical Outlook, “Prevailing Under Pressure.”
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(1) As of date of publication: 23 November 2022.Return to content↩
Aaditya is a senior vice president and portfolio manager focusing on Australian dollar and global portfolios. He has 13 years of investment experience and holds a master's degree in commerce (finance) from the UNSW. He is also a CFA charterholder.