2017 will bring financial conditions in Australian mortgage and housing markets never seen before. The rules of the game have changed and so will the results. The future of the mortgage and housing markets in 2017 may appear uncertain but as we have now entered an era of rising interest rates in the US, a situation not seen for almost 10 years, risks to the downside are significant and locked in.
Whilst the RBA controls Australia’s official cash rate, interest rates set by the Fed in the US are critical to Australia. Australia runs a current account deficit (CAD) and has done so for around 50 years. The CAD is funded by offshore debt to our federal and state governments, and our banks. Australia, as a rule, needs to maintain a premium on its official and actual interest rates over US, Japanese, UK and European rates to ensure that international debt providers stay put and do not withdraw their funds for better relative rates elsewhere. Capital flight would have severe impacts for the Australian financial system.
I have argued before that Australian interest rates could go significantly negative. Reality tempers this view by introducing the inflation constant and I’d change my view to Australia moving heavily into negative real rates although nominal rates could be negative as well. We already have zero to slightly negative real rates but movement into further negative territory will occur before this complex game plays out.
Against this trend in Australia the US Fed itself is predicting on average of at least a 50 bps rise in official rates in 2017. The dilemma for the RBA is whether to follow the Fed to maintain the relative attractiveness of investing in $As, or faced with a weakening Australian economy, the RBA maintains current rates or decreases in order to stimulate. The dilemma is heightened because any significant capital flight will significantly reduce the value of the $A which will make the price of imported goods rise, stimulating inflation forcing the RBA to raise rates. Is this the rock and the hard place?
For a reactionary central banker, there is no rock and hard place here. The RBA will reduce rates as hard as possible. If this causes capital flight then the RBA will react by increasing rates and deflecting blame to offshore investors and government fiscal policy. Yes, the RBA must reduce rates to cause a capital flight crisis to be given the ammunition to increase rates to deflate overblown asset prices. Although this seems a perverse outcome, the journey may have further twists.
A question for the Australian banks is whether Australian interest rates could detach in domestic and international markets? That is, one rate for international borrowing and a lower rate for domestic markets to minimise the impact on mortgage rates? If so, this mechanism could be used to have negative real rates domestically propping up the housing market for a time even if ultimately redistributing wealth more evenly. The banks know the answer and play on it.
When there is capital flight due to official interest rate decreases, the RBA could and would step in and fund the banks’ funding shortfall from a loss of international investors using the Committed Liquidity Facility at rates below the banks’ international funding rates. The CLF used in these circumstances would be a form of quantitive easing and would have a dampening effect on mortgage rates by subsidising bank borrowing rates but could never be a lasting solution and only have limited effect in the long term. So yes, high cost international funding by the banks can easily be replaced by cheap RBA funding through a form of QE or money printing subsidising bank profits and banker bonuses.
So it would seem on balance that Aussie mortgage rates will decrease in the short term and depending on any implementation of macro-prudential measures also boost house prices. Once this is done, the RBA’s hand will likely be forced to significantly increase Australian mortgage rates due to:
· the US Fed raising rates,
· offshore capital flight risk,
· $A lowering against the basket of countries,
· increased federal and state government debt,
· and increasing inflation.
All these risks are only heightened when taken with the high probability that Australia will lose its AAA Rating in 2017 due to a failure to address the structural budget deficit.
Rising interest rates will undoubtedly put pressure on many mortgage borrowers’ ability to service their monthly payments. Whilst,APRA has pressured the banks to increase serviceability requirements in recent years, undoubtedly with house prices and debt levels at record levels relative to household incomes, the borrowers at the margin are likely to be severely impacted by only small interest rate increases.
Many factors effect house prices, but interest rates and mortgage serviceability are generally agreed as significant contributing factors. So whilst the RBA is able to keep mortgage rates constant or decrease rates, house prices should remain at elevated levels. But with developing pressure for both interest rates and serviceability to increase, the likely effect is that house prices or the principal on the mortgage must decrease to compensate. Whilst selling our housing assets to foreign buyers may stave off any immediate plunge in prices, or without any government assistance packages to subsidise price and demand, the outlook for house prices must be highly negative once rates turn, as they surely will.
It follows that the outlook for our banks is neutral in the short term but also negative when rates turn. The risks are on the downside for banks profitability and return on equity over 2017 and 18 due to:
· mortgage borrower stress at the margin,
· decreases in Aus and bank credit ratings,
· collateral values (housing) decreasing on the back book,
· Higher offshore borrowing costs,
· and, probable resulting increases in capital requirements.
Predicting the down turn in our housing and banking markets is fraught with danger with many lost reputations. In the past many pundits predictions failed to take account of the actions that the central bank and governments can take and have taken to maintain the status quo, even if actions were only temporary can kicks. However, 2017 may bring events that these authorities cannot control or soften the outcome but are predictable. Amongst all the events that could occur in international markets, what the Fed does with interest rates will be one of the most important for Australia.