Mortgage shock coming despite RBA doves

Coolabah Capital with the note:

Banks are gradually hiking borrowing costs for a range of reasons that are worth understanding. The first is that these interest rates were being artificially suppressed by the RBA’s suite of cheap money policies. Two particularly potent initiatives were the Term Funding Facility, under which the RBA lent banks $188 billion at an annual cost of 0.1-0.25 per cent, and the now controversial yield curve target, which involved the RBA buying 2-3 year bonds to keep their yield fixed at circa 0.1 per cent.

Both policies have now expired, which means the banks have to pay a lot more to borrow 2-3 year money to lend to households and businesses. This is why they are boosting their 2-3 year fixed interest rates. And they will probably continue doing so until most residential property borrowers are once again using variable- (rather than fixed-) rate products. In fact, we are already seeing banks slash variable rates down to 2 per cent while jacking-up fixed rates from sub-2 per cent to 2.5 per cent or more.

A combination of the RBA lending the banks $188 billion plus a surge in deposit inflows care of massive fiscal stimulus from the Commonwealth and State governments meant that banks did not have to tap wholesale bond markets as much as they have historically. With the RBA’s money due to be repaid over the next few years and deposit inflows likely to attenuate, banks are normalising their funding needs.

As one example, Westpac announced during the week that it expects to issue between $30-$40 billion of wholesale debt this financial year with the actual outcome likely to be at the upper end of that range. And Westpac’s treasurer, Jo Dawson (aka the Queen of Credit), wasted no time, raising US$5.5 billion (about A$7.4 billion) via an unprecedented five simultaneous bond issues in the US market a few days ago. (We participated in three of the issues.)

Following the banks’ reporting season, we have updated our modelling of how much wholesale debt they need to issue in the 2022 calendar year, which is currently around the $150 billion mark. That’s a touch higher than their average run-rate in the 10 years preceding the COVID-19 crisis. One swing factor will be deposit inflows: if they slow, that number will climb.

As investors come to grips with this, they have been normalising the banks’ funding costs. The cost of raising 5-year senior debt in Australia has risen from about 30 basis points over the bank bill swap rate to 60 basis points today. A new 5-year, major bank senior deal would probably have to pay around 70-75 basis points.

With the banks’ net interest margins under pressure, they will pass these costs on to clients in the form of loftier borrowing rates and/or lower deposit returns. Any future financial market shocks will push these funding costs higher, which will only raise the likelihood of unilateral rate hikes from the banking system. We have seen this time and time again since the global financial crisis.

When the RBA calibrates its cash rate settings, it is targeting actual borrowing rates. If banks are lifting borrowing rates outside of any RBA actions, Martin Place will expressly account for this in its own decisioning. This column therefore agrees with Chanticleer’s proposition that the banking system could easily sideline the RBA for some time even in the presence of upside surprises on inflation, wages, and growth more generally.

Another crucial swing factor for the RBA will be the extent to which Federal and State governments can work together to accelerate skilled migration to cauterise the mounting labour shortages in certain sectors (eg, retail, restaurants, cafes and agriculture), which are flowing into higher consumer costs.

We saw in the October unemployment data an encouraging surge in the number of people looking for work—as represented by the participation rate—which pushed-up the jobless rate from 4.6 per cent to 5.2 per cent. As our borders rapidly reopen, there’s a good chance that a flood of vaccinated skilled migrants will help Australia avoid the demonstrable wage-price spirals emerging in the US that are fuelling enormous consumer price inflation.

During the week core inflation in the US printed at over 4 per cent, which is double what the Federal Reserve is targeting and twice as fast as the underlying inflation we are experiencing here. Wages growth in the US has also been running at a 5-6 per cent annualised pace in the last six months, more than double the pace of our wages growth. This is why the RBA has been at pains to stress that Australia’s inflation experience is very different to what is playing out in the US.

Nonetheless, there are commonalities, including rising energy prices and the ripple effects of the COVID-19 shock, which propagated supply shortages that have pushed-up the cost of many items, including building materials and used cars. In the US, rents are soaring as younger folks return to the cities to work. And the labour shortages that are driving higher wages are having second-round impacts on the cost of restaurants, recreation services, household services, and day care.

Here we agree with Terry McCrann’s argument that there is a stunning cognitive dissonance between the Fed’s commitment to targeting 2 per cent core inflation and what it is actually doing. The Fed believes its neutral cash rate is around 2.5 per cent. This is the level of the cash rate that is neither expansionary nor contractionary on the economy. And yet with a jobless rate of just 4.6 per cent and core inflation doubling the Fed’s target, the US cash rate is sitting at just 0.1 per cent.

This is impacting long-term estimates of the Fed’s cash rate as represented by the 10-year US government bond yield, which is only 1.55 per cent. The last time the US experienced a much more modest bout of wage growth in 2018, the 10-year yield jumped to 3.2 per cent, which immediately forced US (and global) equity valuations down about 20 per cent.

The risk for investors is that these long-term interest rates continue to climb back to much more normal levels, which will require a big upward adjustment in the long-term discount rates used to price all asset-classes, including listed equities, private equity, commercial property and infrastructure. And given the very high correlation between both long-term Australian and US interest rates, and Aussie and US equities, it is entirely possible that the much lower inflation Aussie economy is caught up in the cross-fire.

For some bizarre reason, the global equities market appears, for the time being, to be completely ignoring these downside risks. Perhaps, as McCrann argues, equity investors are assuming the Fed will always bail them out. As in 2018, they might feel differently when the Fed eventually gets around to hiking its cash rate.

House price growth should also cool as our banks start normalising borrowing rates. Crucially, this will likely buy the RBA time to sit on the sidelines for as long as wages growth and inflation remain subdued. The latter will in turn hinge critically on the nation’s ability to attract the best and brightest minds to help address our burgeoning labour shortages.

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