The great housing crash has stalled, but is far from over

There is good news and bad news. The bad news is that the good news is more likely than not bad news.

In any event, the good news is that the great Aussie housing crash, which has seen national prices fall about 10 per cent from their peak – the second-largest slump in 43 years – has suddenly stalled.

In February, CoreLogic’s five capital city index has gone sideways. While home values further slide in Brisbane, Melbourne and Adelaide, the rate of decline has slowed sharply.

And in Sydney prices have bounced ever so slightly by 0.3 per cent. Does this presage an end to the correction? Should we now all be diving in to buy property? I don’t think so.

The first thing to understand is that none of this data is seasonally adjusted. And CoreLogic finds house prices generally climb between February and May. March is the seasonally strongest month of the year in terms of capital gains.

In recent times, capital city dwelling values have normally benefited from a seasonal bump of 0.2 per cent in February, CoreLogic says.

If you seasonally adjusted the raw February data, there is a case that prices have continued to grind lower.

Sydney may have also benefited from two other influences. Starting in January, the NSW government is allowing first-time buyers to elect not to pay any stamp duty and instead opt for an annual land tax, enhancing their upfront purchasing power.

Another factor could be anecdotal reports of the return of Chinese buyers with a huge increase in student migration, although this has yet to be properly substantiated.

The bad news is that only a portion of the Reserve Bank of Australia’s 325 basis points worth of interest rate increases have been felt by borrowers thus far.

The central bank estimates that roughly one-third of all home loan borrowers are on fixed-rate products. To date, these fixed-rate borrowers have not worn any rate changes at all.

If one examines the rise in the mortgage rates paid on the total stock of outstanding home loans, including both variable- and fixed-rate products, interest rates have only lifted about 210 basis points since the RBA started tightening monetary policy last May.

Put another way, Aussie households have yet to be hammered by about 115 basis points of the 325 basis points worth of RBA rate increases (or 35 per cent of the total move).

The RBA’s analysis suggests that about half of all fixed-rate borrowers, or a total of $350 billion worth of mortgage debt (close to 900,000 loans), will shift to variable rate in 2023. And these borrowers will be smashed by a huge increase in their cost of capital, which in most instances will jump from about 2 per cent to 6 per cent.

Presenting its results this week, CBA highlighted what the increase in interest rates has done to purchasing power. The maximum borrowing capacity of joint owner-occupied buyers has crashed an incredible 33 per cent to date, which is why house prices have been predictably in freefall.

The concern here is that the RBA is far from done, promising multiple additional interest rate increases, which will only further shrink purchasing power. Its target cash rate is currently 3.35 per cent.

But the bond market is pricing in a peak terminal cash rate of about 4.25 per cent, implying that the RBA will lift interest rates by another 90 basis points.

In the words of the RBA’s board, “Members agreed that further increases in interest rates are likely to be needed over the months ahead”.

Westpac’s weathered RBA watcher, the inimitable Bill Evans, said on Friday he had raised his forecast for the peak cash rate to 4.1 per cent.

Housing inertia temporary

After the RBA began lifting rates in May 2022, we released our own internal modelling last June on what would happen to Australian house prices if the RBA cash rate hit 4.25 per cent and then declined modestly in 2025.

This analysis was carried out using an updated and refined version of the RBA’s own model of the housing market, which accounts for pretty much every demand- and supply side factor you can think of. The RBA’s model showed that prices would need to correct by more than 30 per cent.

The RBA is fond of talking about how households’ excess savings buffers, built up during the pandemic, will help them ride through this never-before-seen interest rate shock.

Yet, the latest data shows that the household savings ratio has almost returned to its average historical level. We’ve been spending like it is 1999 and quickly burning through these buffers. Another wrinkle with the excess savings proposition is that most of this cash is held by folks over the age of 55 with very little debt.

This underscores the concerns unveiled by the RBA’s stress-testing in 2022, which found that if the cash rate were to rise to 3.6 per cent, approximately 15 per cent of all borrowers would have negative free cash-flow (where the latter is defined as incomes less mortgage repayments and essential living expenses).

This number would obviously be even higher at a 4.25 per cent cash rate.

Another claimed mitigant is that Australian borrowers are, on average, many months ahead of their required home loan repayments. But while this may be true in aggregate, RBA data shows that 40 per cent of borrowers are less than three months ahead on their repayments. A big chunk of our society is very vulnerable indeed.

In summary, we continue to expect house prices to decline in 2023 with total peak-to-trough losses in the order of 15 per cent-25 per cent, as we outlined in October 2021.

The current inertia is likely to be temporary and superseded by another period of sustained weakness as the 115 basis points of rate increases that have yet to be felt by borrowers is slowly passed through, as future rate rises contribute to a further compression in purchasing power, and as this unprecedented tightening of monetary policy destroys demand and forces the unemployment rate much higher.

What is worrying is that the markets likely to be most adversely impacted by the coming default cycle are not necessarily pricing in much, if any, economic adversity.

Whereas the liquid high-grade bond market is clearly signalling a high probability of a recession in the US and Europe in the next year, the “high yield” or “junk” debt market is not.

Since 2007, high-yield single “B” rated bonds in the US have paid about 3.5 percentage points in extra annual interest over their much safer and more liquid BBB rated (or investment-grade) alternatives to compensate for the far higher default risk on B rated debt.

Right now, that risk-premium is sitting at only about 3 percentage points (or 13 per cent lower than normal).

What makes this even more striking is that during recessions and periods when defaults are rising, such as in the early 2000s, during the global financial crisis, in financial year 2012 and financial 2016, and in March 2020, the high-yield bond spread to investment grade bonds very consistently jumps north of 6 percentage points.

And yet in 2022, it only peaked at about 4.5 percentage points. Current high-yield risk premia are arguably sitting at half where they should be if we are about to experience a serious default cycle.

So, either the world is peachy and defaults are going to remain benign (despite the record increase in rates), or something else is going on. One explanation could be illiquidity.

Traders report that the riskier high-yield part of the bond market has been plagued by extreme illiquidity since 2021. If you look at the new issue, or primary, market, issuance volumes are sitting at about one-third of their normal levels.

In fact, US high-yield bond issuance has been at its lowest level in more than a decade. Just as with the unlisted commercial property market where valuations have not corrected down properly due to very little trading, the same illiquidity dynamic is probably asserting itself in respect of high-yield bonds.

A lack of trading has meant spreads are being kept artificially tight until defaults materialise and/or high-yield bond issuers are forced to raise money to refinance the wall of maturities looming over the next two years.

Liquid markets have adjusted to the fact that risk-free cash is paying you interest rates of 4 per cent - 5 per cent or more. It could take illiquid investments years to catch up to this new regime where high cash rates have killed the search for yield.

First published in the AFR.