Interest rate rises to trigger $1.6trn debt bomb

September 22, 2017

 

It's springtime here in Australia and there's clearly something in the air.

A week ago it was the National Australia Bank and now it's the ANZ predicting that if all goes to plan the Reserve Bank will be hiking interest rates twice in 2018.

In contrast, Westpac still expects there will be no change to interest rates next year, thanks to the ongoing weakness in household income growth, while the Commonwealth Bank doesn't think the RBA will lift the cash rate until late next year.

But in a note to clients on Wednesday, the CBA was quick to add the risk of an earlier move is definitely on the rise.

 

For sure the big call from the ANZ and NAB means the economic data has to eventually bloom like the flowers do at this time of the year, but the main reason it's all so important is the impact interest rates have on the housing market.

 

The prediction of a higher cash rate coincided with a report from Capital Economics on Wednesday that said property prices in Sydney and Melbourne are up to 30 per cent over-valued but won't fall until the RBA starts to hike rates.

Well, if the RBA is getting ready to hike it implies investors should get ready for a fall in house prices.

So far the main reason why households haven't had to worry about their balance sheets, or wealth, is that house prices have gone through the roof.

There's around $1.6 trillion of debt linked to the residential property market for investors and owner occupiers, but the value of all that property now stands at around $6.7 trillion.

 

When rates rise, however, that debt number stays roughly the same but paying for it all goes up and if Capital Economics is right there will be a fall of 10 per cent in prices.

That takes the total value of housing closer to $6 trillion, but if its closer to a 20 per cent fall then it dips to $5.36 trillion.

It shows why the balance sheets of households with a mortgage are so exposed to a drop in house prices.

While everyone seems to point to the household debt relative to disposable income, that has reached the record high of 200 per cent, it's really the ability to service the debt that is the ticking time bomb.

 

Money has become so cheap over the past 40 years that when interest rates start to rise it's a fair bet it will have more of an impact than what everyone thinks now.

Already the sell-off in the bond market has been significant.

The yield on the benchmark three-year government bond this financial year has jumped to 2.18 per cent from 1.76 per cent, while the yield on the 10 year bond has increased from 2.40 per cent to 2.83 per cent.

 

Not that overvalued

 

It's easy to underestimate how much of an impact 40 years of falling interest rates has had on all asset prices, not just property.

Indeed, according to Paul Dales, chief economist at Capital Economics, once you adjust for the fall in rates, the local housing market isn't as overvalued as some experts think.

One reason why house prices have been called overvalued is the current house price to earnings ratio of 5.8, for all capital cities, that is way higher than the historical average of, since 1980, around 3.6.

But as Dales says, that doesn't take into account the "permanent decline in interest rates" that means "buyers are now willing to accept a much lower annual return from housing".

 

As interest rates fell and money became so cheap households were emboldened to take on more debt.

As house prices went up it all looked so good but now that trade could be unwinding.

It all comes as the Reserve Bank's assistant governor Luci Ellis said in a speech that the global economy has now passed a 'turning point' and investors will have to adjust a new era of better growth and higher interest rates.

If wages start to grow, on the back of this economic growth, and disposable incomes continue to grow then maybe house prices may not need to fall that much and the debt can be paid back quicker.

But the risk is some households get nervous as the value of their prized asset falls and ultimately, if rates rise, they might be forced to sell.

If too many households sell their property then prices fall further and the whole housing cycle moves into a downward trajectory.


Read more: http://www.afr.com/markets/equity-markets/interest-rate-rises-to-trigger-16trn-debt-bomb-20170920-gykyps?btis#ixzz4tNGxbgPk
 

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