Housing prices at a signal junction: Christopher Joye

Australia’s housing market has been given a reprieve, and likely rests at a crucial junction. Perversely, alongside cash investments, housing could prove to be a partial proxy for catastrophe insurance.

A year ago, many of the nation’s top economists were expecting that the RBA’s official cash rate would rise from 4.5%, where it was at the time, to between 5.5% and 6%.

In September 2010, Paul Bloxham was appointed chief economist for HSBC after having spent 11 years working at the RBA. Bloxham immediately junked the forecasts left by his predecessor, John Edwards, who now, ironically, sits on the RBA’s noard, and announced a new forecast of 5.75% for the end 2011 cash rate.

Had Bloxham proven correct, mortgage rates would be heading towards 8.8% today. Yet they remain a full percentage point lower.

According to the RBA, the official standard variable mortgage rate is 7.8%, which is only slightly above its 15-year average. The official discounted variable rate is just 7.05%. And in the past month or two, the cost of fixed-rate home loans has crashed, with deals as low as 6.35% now available from the likes of Members Equity Bank.

As it turned out, we have only suffered one official rate hike, in November last year, notwithstanding that the big banks saw fit to add another 0.2 percentage points to the RBA’s increase to deliver a de facto double hike.

A related dynamic asserting itself in Australia’s housing market has been the “hawkish” Australian consumer. Borrowers have been acting as if they were certain to get slammed by another two to three rate increases, according to Westpac-Melbourne Institute survey data.

As late as August this year, about 29% of all people were still banking on four or more hikes. The net effect of all these “phantom hikes” was to place a heavy clamp on housing demand.

As UBS’s Matt Johnson put it, the cost of capital in the housing market was starting to look like it would exceed the projected returns.

There have been at least four important developments that have pushed Australia’s interest rate cycle off course, and which may mean that the housing market is about to turn a corner. The first I want to talk about arrived yesterday.

The Australian Bureau of Statistics released revisions to its recent inflation numbers that have quite materially altered the previously understood inflation dynamics.

This was an unusual innovation: the ABS ordinarily never revises its CPI estimates, for good reason (wages are determined on the basis of these findings).

However, the ABS will, as at the date of the next inflation release, adopt a new methodology to “seasonally adjust” its inflation numbers. So yesterday it showed us the impact of the new method on past releases.

In summary, the long-term “core” or “underlying” measures of inflation were revised slightly higher. More latterly, the final 2010 quarter estimate was upgraded. The first quarter of this year was unchanged at 0.85%. But, crucially, the surprisingly high second quarter core inflation result for 2011 was materially downgraded from 0.9% to 0.6% (the year-on-year core inflation outcomes were similar).

At face value, this quite significantly changes one’s conclusions about the current inflation trajectory. Before we get too excited about the prospect of a benign inflation environment, we will need to wait until next week when the ABS unveils yet another round of revisions. Some commentators have speculated that these may generate further downgrades.

The bottom line is that core inflation in the first half of 2011 is now believed to have been running at a (still high) 2.9% pace rather than the ABS’s much stronger 3.4% plus rate.

This is good news for the housing market. If these numbers are not perturbed by additional ABS adjustments, it means that the RBA has more time to sit pat and watch how things unfold. If the third-quarter inflation numbers that are published in late October print low, some of the major obstacles to the RBA reducing rates will have been removed.

As I showed in Tuesday’s column, the financial markets are now predicting that we will have five to six rate cuts by July next year. Many credible institutions, like AMP, Goldman Sachs, Deutsche, Macquarie and Westpac, all think the next move in rates will be down. This is starting to feed back into consumer confidence, which is the second major factor I want to canvass here.

Yesterday the market was surprised by a very robust rebound in the consumer confidence data back towards its historical average. There is little doubt in my mind that this is being motivated by a big shift in community attitudes around interest rates. Many people are starting to accept that rates will likely remain on hold for the foreseeable future. A much larger share now think rates will actually fall. And fewer are budgeting on the very high four-plus hikes documented previously.

The third development has been the rise in the unemployment rate from its low of about 4.9% to the current 5.3% level. While there are sound reasons to believe that the labour market is not as weak as this spike implies, it still has significant consequences for monetary policy. According to the RBA, the unemployment rate is one of its most valuable guides to future inflation.

The RBA had been looking for unemployment to slowly slide towards 4.5%. Alongside the inflation revisions, the recent slackening in Australia’s labour market affords much ammunition for those arguing that rates should be cut, or at least held at current levels.

The final dynamic worthy of mention is the offshore turbulence. Many smart observers think there is a real risk that Greece will, one way or another, exit the Euro zone and drop the common currency in favour of a new one. The argument goes that it is very likely Greece will default on its debts, which will mean net present value losses for the holders of those bonds—mainly European banks and the European Central Bank—of between 60 and 80%.

Rather than subject itself to the burden of external austerity conditions, Greece may choose to swap the Euro currency for a “New Drachma”.

The idea would be to then allow the New Drachma to depreciate significantly, and thereby make Greek goods much less expensive relative to their current prices. The problem with this strategy is, according to Euro experts, that it would almost certainly lead to the complete collapse of the Greek banking system, which would no longer have access to foreign or ECB funding. It would also perpetuate big losses across the European banking sector (hence the recent ratings downgrades by Moody’s), which could in turn compel these banks to ration credit to other borrowers. Over and above the extreme financial market volatility that a Greek exit from the Euro zone would invariably trigger, it would likely place more downward pressure on the already weak economic growth that prevails today.

More worryingly, experts believe that if Greece goes, this will boost the probability that the likes of Portugal, Ireland, Spain and even Italy or Germany follow. That is, the entire Euro zone could implode. UBS figures that this would lead to massive reductions in economic output across all nations and thus a deep regional recession, if not depression.

So while all of the above might still reside in the “lower probability” camp, it is more than sufficient to give the RBA pause, if not add to the evidence pointing to the need to relax policy.

The key insight here is that this could be perversely beneficial to Australia’s housing market, in which around 90% of borrowers have fully variable-rate debt.

As I have observed before, the RBA has been explicit in stating that it would crimp activity in the consumer and housing sectors in order to “make room” for Australia’s resources boom.

Based on the GDP data published by the ABS over the last nine months, it transpires that consumer spending, and private demand generally, have been healthier than perhaps even the RBA anticipated.

Ordinarily this would connote higher rates. But the economic forces sketched above have conspired against this outcome.

I have repeatedly argued that the highly interest-rate-sensitive household sector would be a good hedge against a collapse in Australia’s resources narrative. If the latter were to happen, the RBA would slash rates, which, alongside a much lower Australian dollar, would strongly stimulate consumption and housing demand. The policymakers’ plan would be for these two areas to, in effect, step into the breach left by a derailed resources sector.

In this respect, it is plausible that Australia’s currently soft housing market will emerge as a relative winner from any global fall-out, much as it did in 2007-08.