Thanks to the Reserve Bank of Australia’s extraordinary decision to hammer unsuspecting households with 125 basis points of mortgage rate increases in just two months (from May 4 to July 6), which will likely be upsized to 175 basis points of rises at its next meeting, Sydney house prices are falling at a 20 per cent-plus annualised pace.
Using the daily hedonic index data published by CoreLogic, which is the RBA’s preferred housing benchmark, this column finds that the rolling 30-day change in Sydney home values has dropped precipitously from 2.83 per cent in August 2021 to minus 2.21 per cent as at July 11. That means residential real estate in Sydney is declining at an annualised rate comfortably north of 20 per cent.
While this housing crash appears to have shocked many analysts and economists – and the millions of unwitting families relentlessly advised by the RBA in 2020 and 2021 to borrow and spend as much as possible because Martin Place had committed not to lift interest rates until 2024 at the earliest – it is, regrettably, smack bang in line with the central case that this column outlined late last year.
In June, Sydney home values plunged 1.6 per cent. They have fallen at an even more rapid rate over the first 11 days of July, slumping by another 0.7 per cent.
Melbourne dwelling values are closely tracking Sydney prices, albeit with a lag. In June, Melbourne home values fell 1.1 per cent, and they have lost another 0.4 per cent in the first few weeks of July.
Sadly, this reaffirms our dour October 2021 forecast that local house prices would correct 15-25 per cent after the first 100 basis points of the RBA increases, smashing consumer and business confidence (already near GFC lows) and adversely affecting consumption across the economy.
This has slowly become a consensus economist view, although there are some spruikers who claim house prices will continue climbing because higher interest rates have no impact on them.
It’s also worth noting that we are not perma-bears when it comes to Aussie housing. On the contrary, we were the most bullish forecasters in early 2020 when everyone else was expecting prices to drop 10-20 per cent.
While the RBA is setting itself up to increase rates by another 50 basis points in August in response to lagged inflation data heavily influenced by temporary supply-side shocks, we project that the record collapse in the value of Aussie households’ most important asset will ultimately act as a constraint on the extent to which Martin Place can continue to lift rates. After preemptively over-egging policy despite no evidence of a wage/price spiral, there is every chance the RBA will be forced to cut rates in 2023. (Recall the latest CBA data on real-time wage growth suggests it remains very sluggish.)
Aussie households face multiple headwinds: the fastest interest rate increases in a quarter of a century, which are crushing disposable incomes; a massive, albeit hopefully temporary, reduction in real wage growth as a result of a one-off increase in inflation attributable to a conga line of supply-side shocks; a record decline in the value of their largest asset, the owner-occupied home; the largest decline in the value of their superannuation savings since the GFC; and finally, the spectre of fiscal policy dragging on growth as both the federal and state governments eventually turn their focus to budget repair and the need to raise taxes.
On this final point, there have been some interesting developments. This month Victoria commendably raised $7.9 billion from the partial sale of VicRoads. Treasurer Tim Pallas confirmed the funds will go to the state’s new Future Fund that will be used to pay back the tens of billions of dollars of COVID-related debt that Victorian taxpayers have accumulated since 2020. This is modelled on NSW’s excellent Debt Retirement Fund, which NSW has already tapped for $11 billion to help repay its COVID-19 debt bill.
Following the budgets released by the five largest states, we know that the official debt issuance task will be $75.6 billion for the 2023 financial year, which is $10.1 billion less than the $85.7 billion these states forecast for FY23 at the time of their FY22 budgets.
If one accounts for the amount of rapid-fire issuance the likes of NSW and Victoria have been able to do via their record floating-rate note deals, which have attracted $17 billion of bids from banks hungry for high-quality liquid assets, the states’ funding task for FY23 falls from the most recent budget estimate of $75.6 billion to just $64 billion. That is, the five largest states have exactly $10 billion less debt to issue in FY23 compared to their official numbers only a month ago. The $64 billion of issuance in FY23 is also a striking reduction from the $93 billion issued in FY22 and the $98 billion supplied in FY21.
Juxtaposed against the modest issuance outlook is the gargantuan demand from banks hunting for liquid assets, which this column has been flagging since late 2021. On our estimates, banks will need to buy $315 billion-$570 billion of government bonds through to December 2024.
This is because they lose $140 billion of liquid assets after the Australian Prudential Regulation Authority’s decision to shutter the banks’ lucrative Committed Liquidity Facility, which we foreshadowed last year, and then another $188 billion of liquid assets once they repay the money they borrowed from the RBA under the Term Funding Facility. Balance sheet growth and bond maturities off the RBA’s balance sheet also drive additional bank demand for liquid assets.
Our liquidity shortfall estimates are based on banks maintaining their liquidity coverage ratios (LCRs) at more than 130 per cent. UBS arrives at a slightly smaller $275 billion-$375 billion estimate assuming banks can drop their LCRs to 125 per cent. CBA’s researchers displayed even more hope, claiming that banks might be able to get away with 120 per cent LCRs.
There are two problems with this. Treasurers at the major banks dismiss any possibility of them lowering their board-mandated LCR targets. And APRA has recently noted quite pointedly that banks have prudently kept their LCRs in excess of 130 per cent in line with global peers.
Despite this extremely positive demand and supply, the states have had to wear an enormous increase in their cost of debt funding, which has more than tripled. The first driver has been the spike in Australia’s 10-year Commonwealth bond yield, which was around 1 per cent last year and has since leapt to about 3.5 per cent.
Rightly or wrongly, the implicitly Commonwealth-guaranteed states borrow at a margin above the Commonwealth yield curve and this spread has jumped from 15 basis points last year to about 60-65 basis points this month, broadly in line with where state spreads traded in the unprecedented financial market shock induced by the pandemic in March 2020.
State bonds are the only bonds we know of in global credit markets that are trading anywhere near their March 2020 spread levels. This is one reason we like holding them. As an example, five-year major bank hybrids spreads are sitting at about 330 basis points above the bank bill swap rate. Back in March 2020, hybrid spreads traded as wide as 850 basis points over this.
So what explains the unusual jump in the states’ spreads above the Commonwealth curve? An equally unusual increase in hedging costs, as represented by “swap spreads”, which have exploded to record levels in the post-centralised clearing period. The principal catalyst has been the RBA blowing up global investors who believed that Martin Place would fulfil its commitment not to raise interest rates until 2024 at the earliest.
The RBA had explicitly backed this commitment by fixing the interest rate on the 2024 Commonwealth bond at 0.1 per cent, the same level as its target cash rate. But in October 2021, it suddenly decided to stop defending this “peg”, which was arguably the most humiliating experience for a central bank since George Soros rolled the Bank of England in the early 1990s.
As the RBA concedes in a recent report, this damaged its credibility and king-hit global investors that had allocated capital on the assumption that the RBA’s 2024 yield curve target would remain intact.
There has been market chatter that it has taken larger investors until recent days to exit their long, or received, positions in the 10-year Aussie swaps market, which they had been stopping out of since last October. The process of stopping out of these trades over the past eight months has relentlessly pushed local swap spreads higher, eventually to levels that were more than double the previous peaks recorded in the post-clearing period.
The good news is that since these flows have cleared, spreads have started their long process of normalising back towards their fundamental anchor.SI
Christopher Joye is a portfolio manager with Coolabah Capital, which invests in fixed-income securities.
