Sydney, Melbourne’s great house price correction has begun

This process began in November when the Reserve Bank suddenly dropped its pledge not to raise interest rates until 2024 and its so-called yield curve target of keeping the 2024 Treasury bond yield at 0.1 percent. with its target overnight cash interest.

A second driver was market perception that the RBA would begin raising rates this year, which hit popular consciousness in late 2021 after the RBA ditched its forecasts to start only in 2024. A series of hikes this year were fully priced in by markets in November 2021, widely communicated by the media.

A third headwind was that the RBA began the process of normalizing monetary policy with an inaugural 0.25 percentage point hike in cash interest rates in May 2022 (a month ahead of the explicit plan it outlined in April and that an initial hike was targeted in June), which resulted in variable-rate mortgage costs rising by the same margin.

A fourth factor was that RBA Governor Philip Lowe advised the public in May that he expects to raise his target cash interest rate to at least 2.5 percent, which would mean the cost of floating-rate mortgages will rise from about 2 percent before the RBA’s May rises to 4.5 percent once the spot rate hits 2.5 percent.

Financial markets take a much more aggressive view: they are pricing in a terminal RBA cash rate of 3.7 percent, which would imply that floating-rate mortgages will rise to 5.6 percent.

Finally, there is a generic increase in lenders’ borrowing costs. This includes both banks and non-banks. Financing costs were unusually low due to the fact that the RBA lent the banks $188 billion annually at a super-cheap cost of between 0.1 percent and 0.25 percent. This facility is no longer available and will have to be repaid in the coming years.

As a result, borrowing costs have fallen back to the average, and it is reasonable to assume that some of these costs will be passed on to borrowers in the form of off-cycle lender-imposed increases. However, these must be neutralized by the RBA: any extras that lenders pass on to borrowers are increases that the RBA doesn’t have to impose on itself (since the RBA practically targets a certain level of borrowing rates).

Last October, we expected at least another 5 percent of capital gains nationally before the Australian housing market started to roll over (the CoreLogic index returned 5.4 percent between November 1 and April 30).

Orderly Correction

We argued that after the RBA started raising rates in mid-2022 at the earliest (they had planned to start in June, got the yips and started in May), the first 100 basis points of rate hikes would lead to a subsequent 15-25 percent correction in national home values. This would be the biggest drop ever. Thanks to CoreLogic, we now know that the big Aussie housing correction has indeed begun.

While capital losses may be bad for homeowners, they have posted capital gains of 37 percent since the RBA first cut the cash interest rate below 1.5 percent in June 2019 (it’s currently 0.35 percent after the 0.25 percentage point increase). in May).

If we are right and correct the national values ​​by 15-25 percent in the coming years, that will be a modest payback.

We also believe that this correction will proceed in an orderly fashion given the overall strength of the economy, which is likely to be supported by a number of factors.

These include: a low and competitive Aussie dollar, helping exporters and import-competitive industries; very strong population growth, driven by skilled and unskilled migration, which will boost aggregate demand; a revolution in corporate lending as companies seek to invest in their manufacturing capacity given lingering supply-side constraints coupled with a massive surge in supply chain restocking as economies decouple from China; increased prices for all of Australia’s major exports, including agriculture, iron ore, natural gas and coal; and ongoing fiscal stimulus from structural deficits at the federal level, exacerbated by the need to spend massive amounts on national security, and robust infrastructure investment programs from both the Feds and the states.

One dynamic that is not particularly well understood is how the treasury benefits from inflation. In the case of the states, they collect GST revenue, which is a direct inflation tax. They also earn payroll tax income, which is a payroll tax. Clearly, the Feds are benefiting from income taxes that rise as wages rise.

Upside surprises to tax revenues are a major reason why federal and state budget deficits for the current fiscal year have been massively revised downwards, as we long anticipated.

There is also no shortage of demand for government bonds, as Victoria underlined on Thursday with another record-breaking bond deal. Treasury Corporation of Victoria launched dual-tranche 2028 and 2030 floating-rate notes that drew unprecedented demand of $8.1 billion, ultimately allowing TCV to print a record $4.4 billion across the two FRNs (we bought both).

This was a smart trade: Victorian taxpayers pay only about 1.3 percent annual interest on the FRNs, compared to the 4.2 percent they would pay on a normal 10-year fixed-rate bond. Judging by what taxpayers do with their own money, it’s what they want too: Nearly all new home loan approvals these days are for variable-rate mortgages that cost 2.25 percent, half the price of the typical three-year fixed-rate loan. which charges 4.5 percent annually.

The main investors in the FRNs have been banks, which will have to buy between $315 billion and $570 billion in government bonds over the next 2.5 years to meet regulatory liquidity requirements. While there had been some discussion about the magnitude of banks’ demand for government bonds, TCV’s transaction put that topic to bed.

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