It is time to unveil a new expectation: if the RBA continues cutting through conventional and unconventional means, which is our central case, I expect that this economic cycle house prices will likely increase by about 30% with no immediate financial stability hazards. This follows on from our April 2019 projection that the 10% draw-down in Australian house prices (which we correctly predicted in April 2017) was coming to an end and would be followed by a 10% increase in national prices over the 12 months following the second RBA rate cut. We are well and truly on track to meet that contrarian call with national home values rising by 0.1% in July, 1.0% in August, 1.1% in September and 1.4% in October according to the best index provider, CoreLogic (I actually founded the business that developed this hedonic index intellectual property, which was sold to CoreLogic). The table and chart below from Westpac summarise the latest data. The not-so-good news is that we are also going to eventually see a return of sub-prime lending, or, more technically, senior-sub-prime loans (ie, better than the junk that was written prior to the GFC, but a lot worse in lending standard terms than the very conservative loans APRA-regulated banks are writing). I discuss all of this plus the emergence of a new intellectual paradigm inside the RBA in my latest column, which you can read here (AFR subs click here). Excerpt enclosed:
There are bona-fide financial stability hazards over the long-run, especially given our expectation since 2016 that there will be a huge increase in lightly regulated non-bank lending as a result of a boom in securitisation coupled with an unprecedented regulatory crack-down on the ability of banks to compete with these entities. In fact, we are forecasting a surge in sub-prime lending by non-banks tapping risk-agnostic capital desperately searching for yield, including mums and dads investing in sub-prime mortgage trusts similar to the ones that blew-up during the global financial crisis. How history repeats itself! And our peak-to-trough prediction for national house prices during this upswing, which could span years, is an increase of about 30 per cent (or about 60 per cent the size of the last boom).
While this might give one pause, the RBA knows it can instantly cauterise financial stability perturbations through interest rate increases and/or the introduction of “macro-prudential” constraints on lending standards and credit creation, as APRA compellingly demonstrated during the prior bull market. It was, in truth, precisely these interventions that precipitated the 11 per cent decline in house prices (with a shove from the Royal Commission’s irrational take on “responsible lending” and the spectre of Labor’s capital gains tax and negative gearing policies crushing housing investors’ returns).
The final dimension of this analysis is the RBA’s recognition that it has missed its inflation and employment targets for years. This means we are left with an emboldened institution that has high conviction it should do everything within its power to continue to reduce the cost of capital until such a time as it has confidence that its inflation, employment and prosperity triangle is standing strong and true. Right now, it lies in pieces on the ground.
One thing Lowe has ruled out is negative interest rates. Accepting, therefore, that there is an effective lower bound on the RBA’s target cash rate of circa 0.5 per cent beyond which it would fundamentally threaten the viability of banks, the RBA has no choice but to consider alternatives. The Commonwealth Treasury and Westpac’s prescient chief economist, Bill Evans, have confirmed this column’s analysis that this will likely involve targeting a wider range of interest over and above the overnight cash rate and its longer-term siblings as represented by the risk-free interest rates on government bonds.
Treasury has advised Joshua Frydenberg that “given that Australia’s financial system is dominated by bank lending to households it is likely the would first consider options aimed at lowering bank funding costs or supporting mortgage funding directly”. “This would involve either buying commercial bank bills or residential mortgage backed securities,” Treasury continued. “The latter may be particularly attractive as the RBA already holds these assets as collateral as part of its existing operations.”
Treasury further supported our arguments that simply buying government bonds to reduce risk-free yields is unlikely to trigger either a wave of public borrowing because of this government’s prudent commitment to repaying debt and/or private credit creation given most interest rates price off short-term bank funding costs, not long-term government bond yields.
Westpac’s Evans also noted that “locking up a substantial portion of the available government bonds on the RBA’s balance sheet might be counterproductive” because the “limited free supply” of these assets could mean the RBA undermines their liquidity. “On the other hand, purchases by the RBA of residential mortgage backed securities (RMBS) are likely to provide considerable support for the monetary transmission process… lowering funding spreads and providing the RBA with a sharp boost to its monetary accommodation objectives,” Evans wrote.
One problem with RMBS is that there is, again, only a limited stock of “repurchase-eligible” assets and they only fund home loans, not corporate and small business finance, which is where the lending deficiency is more acute. This is why this column (previously) and Treasury and Evans have concluded that any QE program contemplated by the RBA will likely have to consider term lending to banks via repurchase agreements and/or purchases of repo-eligible assets, including senior bank bonds, which is another, arguably cleaner, form of funding alongside the private sector agent.
As the RBA reduces bank funding costs, this should assist in compressing otherwise elevated credit spreads on related securities it cannot touch, including bank hybrids that were recently upgraded by Standard & Poor’s into the BBB rated investment-grade bucket (as we had projected years ago).