A lot of attention is given to the RBA’s nervousness about house prices getting too high, but there is a broader link between house prices and interest rates that could have an increasing impact on our long term economy
The higher the average house price, the higher the average mortgage. That’s fairly obvious. The higher the average mortgage, the higher the mortgage interest costs for any given interest rate. Also obvious. And, if the RBA increases rates, mortgage interest costs also go up.
Let’s take that one step further. The higher that house prices rise relative to household incomes, the more sensitive the entire economy becomes to the overall level of interest rates. Each 25 basis point or 0.25% increase represents a greater shock to consumer spending.
Back in 1994, mortgage rates were around 9% per annum, and interest payments on the average mortgage were 16% of household income. In 2017, house prices have risen more than four-fold, incomes have risen 177%, and mortgage rates average 5.4%. Combined, this means that interest as a percentage of the average household’s income is the same as 1994. Figure 1 illustrates this point.
Mortgage interest costs as a percentage of average household income
Figure 1
Source: ABS
However, a 2% increase in rates in 1994 would have taken interest as a share of household income to 19.8%, whereas a 2% increase today would take it to 22.1%. That difference is significant when it directly translates into lower consumer spending elsewhere in the economy. Essentially, the RBA loses more and more flexibility the higher housing prices move.
Interest rates are supposed to be a lever for central banks to encourage businesses to invest more (or less), and therefore create more (or less), demand for labour. However the higher that housing prices get, the less influence rates have on businesses relative to the impact on consumer spending. Beyond their concern about financial stability, a potential housing market correction is the other reason central banks don’t like to see housing prices get too far ahead of income growth in the long term.
US vs Australia – Argument for tightening interest rate differential due to housing prices
Using this same metric of the percentage of household incomes taken up by mortgage interest payments, the US central bank (the Fed) has a lot more flexibility to increase interest rates than our RBA. To shift the average interest payment back to the US’ long term average, the Fed would need to increase rates another seven times or by 1.75% pa; in Australia, rates would only need to go up two times or by 0.50% pa. That doesn’t take into account that US wage growth is rising much faster compared to Australia, giving the Fed even more flexibility to raise rates.
Conclusion
Last week we showed an economic scorecard for the US versus Australia, concluding that the US economy was stronger on many fronts that the case for a much tighter interest rate differential between the two countries was mounting quickly. This discussion about housing prices is really just one example of last week’s point, but further illustrates the argument for lower interest rates in Australia and a lower Australian dollar.
The current five year yield curve in Australia is 2.28% per annum. With cash rates at 1.50% per annum today, this implies that rates need to rise very quickly now and stay high, or if they are to stay low for the next 1-2 years as per most people’s expectations (and certainly ours), rates would then need to climb to 3% per annum or higher in 2019-2022. Given the very low inflation environment, low and falling wage growth (the major driver of inflation), it is hard to see the argument for such a steep recovery and increase in rates in that space of time.
In our view, the five year yield offers good value for investors at the current levels and could see a fall in yield (rise in price) in the coming weeks as markets start to come to terms with the flat outlook for the Australian domestic economy. While it is easy to get swept up in the media rhetoric about rising interest rates and seek out floating rate notes, FIIG retains the view that the market is getting ahead of itself again, and that rates will be lower for longer than they currently expect.