House prices to get whacked by rates again

The Fair Work Commission’s decision to boost the minimum wage by 8.65 per cent and award wages by 5.75 per cent, which will ultimately affect more than one in four workers, heightens pressure on the Reserve Bank of Australia to lift the cash rate again this month following the upside surprise to the April inflation data.

The RBA is deeply concerned that these non-productivity-linked wage rises will entrench what already appears to be a nascent wage-price spiral that is driving accelerating demand-side inflation, as evidenced by the escalating cost of services (in contrast to the disinflation manifest in supply side-influenced goods prices).

Based on the RBA’s forecast profile for wages, Coolabah estimates that the central bank was technically assuming a more benign circa 4.6 per cent increase in the minimum wage and award wages. Given unchanged productivity, the RBA will now be projecting even higher inflation, with the corollary that its terminal cash rate will also need to be lifted by perhaps another 25 to 50 basis points.

The RBA is also probably exercised that talk of the end of the hiking cycle earlier this year contributed to triggering a bounce in house prices that risks reigniting a positive wealth effect that will necessitate even tighter monetary policy.

In the five biggest capital cities, home values had declined from their peak in May last year (which coincided with the RBA’s first rate rise) by exactly 10 per cent in February. In Sydney, the peak-to-trough fall was much steeper again at precisely 14 per cent. In inflation-adjusted terms, the correction in capital city dwelling values was roughly 16 per cent.

In October 2021, Coolabah projected that this monetary policy cycle should trigger a total decline in home values in the order of 15-25 per cent in nominal terms. (We have not adjusted this view since.) Applying the RBA’s model of the housing market, which we calibrated with a terminal cash rate of 4.25 per cent, the maximum nominal drawdown was implied at north of 30 per cent.

Change in purchasing power

A simpler way to think about house prices is to examine changes in borrowers’ purchasing power over time. According to our analysis, the median household has suffered a 29 per cent reduction in purchasing power since the RBA started lifting rates last year. (This assumes the RBA raises its cash rate to 4.1 per cent next week, which it should do.)

This purchasing power framework accounts for changes in both household incomes and mortgage rates over time. In recent freedom of information disclosures, the RBA revealed internal modelling that showed it would need to boost its cash rate to 4.8 per cent to get inflation back to the mid-point of its 2-3 per cent target band by June 2025.

If the cash rate does indeed hit 4.8 per cent, it would mean that purchasing power has been eroded by a total of 33 per cent since the RBA kicked off this cycle in May last year. In dollar terms, the value of a home that the median household could afford to buy will have slumped from $773,000 in March last year to $515,000 after the cash rate touches 4.8 per cent.

Interestingly, that $515,000 price that the median household can practically afford to buy given a 4.8 per cent cash rate is some 21 per cent below the current $651,000 median dwelling price across Australia.

All roads seem to suggest that the ebullient bounce in house prices in the seasonally strong period between February and May is likely to be superseded by a much more dour environment in which property prices recommence their record slide back to fair value in the second half of the year.

Recession risks

This should be amplified by an increase in unemployment amid what will probably be a global recession. Since January last year, Coolabah has been forecasting a US recession late this year or early next year based on models that use both bond and equity market data.

We recently extended this analysis to a new model developed by Harvard academics Larry Summers and Alex Domash, which the RBA has referenced in its recent work quantifying the risk of a recession in Australia.

The Summers and Domash model focuses on the trend in inflation and recent unemployment, and indirectly captures the policy response to high inflation and low unemployment, where the US Federal Reserve normally needs restrictive monetary policy to deal with uncomfortably high inflation and unsustainably low unemployment.

“The results suggest that at the start of this year, the estimated probability that the US will enter a recession is about 66 per cent over the coming year and climbs to about 90 per cent within the next two years,” Kieran Davies, Coolabah’s chief macro strategist, says.

“These are high probabilities by the standards of the model and well above the observed historical risk that the US will enter a recession, which is not surprising given that inflation recently reached its highest level since the 1980s and unemployment fell to its lowest level in about 50 years.”

These findings also correlate with Coolabah’s yield curve-based recession forecasting model, which points to a historically elevated probability of a recession late this year or early next year.

The RBA has also done some fascinating work on this subject. In one recent piece of research, the RBA took its own forecasts as given and found there was only a 50 per cent chance of the central bank achieving its “narrow path”, which it defines as inflation returning to target without requiring a recession.

An alternative model that adopts a “more flexible approach for exploring recession probabilities” that is “less dependent on [the RBA’s] central forecasts and can make greater use of historical information” paints a more pessimistic picture. This estimates “the chance of a recession in the next two years at 65 to 80 per cent”, the RBA says.

Worse defaults since 1991 likely

This is one reason why we are very focused on the current default cycle, which is likely to be the worst Australia has experienced since the 1991 recession.

While we have yet to observe a material increase in delinquencies on bank balance sheets, there has been a very sharp jump in the 30 days-plus arrears reported by unregulated non-bank home loan lenders in both their prime and sub-prime mortgage pools.

In the sub-prime mortgage space, 30 days or more arrears have doubled from about 2 per cent to circa 4 per cent of all borrowers, and this is likely to continue to climb. Recall that the RBA found that at a 3.6 per cent cash rate, an incredible 15 per cent of all Aussie borrowers would have negative cash flows. The cash rate is 3.85 per cent and could be heading towards 4.8 per cent.

We are, of course, even more closely inspecting the heavily regulated banks. This week, our 38-person team picked up a non-trivial error in Bendigo Bank’s quarterly Pillar 3 risk report. We noted a sudden increase in Bendigo’s corporate non-performing loans, which had superficially leapt from nothing to $474.7 million in March this year. Neither Bendigo nor any other analysts appeared to have noticed.

When we queried Bendigo about the matter, it conceded that it had made a classification error, which was corrected via an ASX release updating the Pillar 3 regulatory report. A change in the regulator’s definition of a non-performing loan, which broadened it considerably, had also contributed to a generalised increase in reported delinquencies.

If you would like to find out more about our fixed-income strategies, including the new Floating-Rate High Yield Fund, please go here. First published in the AFR.