The Rate Debate
What do you get when you throw a 36-year-fixed-income veteran into the room with a 26-year-old fixed-income millennial? The Rate Debate.
Darren Langer and Jess Ren are seasoned fixed income specialists with a deep passion for bond markets and an opinion on just about everything. And while they may sit facing each other at work, they don’t always see eye-to-eye.
Tune-in each month to hear their take on the RBA’s interest rate decision and other macro matters influencing markets.
The Rate Debate
Ep31: No sign of a pause from the RBA as the risk of mortgage stress intensifies
Australia’s central bank has now raised interest rates five months in a row. It’s the most aggressive tightening cycle since 1994. With more hikes expected, and house prices in Sydney and Melbourne on the slide, cracks are starting to appear.
Chris Rands and Darren Langer discuss how further rate hikes will impact the housing market, unemployment rate, and the wider economy in episode 31 of The Rate Debate.
Hello, and welcome to the rate debate. I'm Darren Langer co-head of fixed income at Yara capital. And joining me as my co-portfolio manager, Chris rans.
Speaker 2:Hello everyone.
Speaker 1:Well, it's the first Tuesday of September and that means the RBA has just met and, uh, as expected, uh, they win another 50 basis points, hiring, uh, rates. Let's now the, the fourth, uh, lot of 50 and the fifth rate hike in a row, which is pretty much, uh, the fastest pace the RBA has ever hiked. Um, certainly not the largest magnitude, but it's certainly the fastest pace. It's was interesting looking at the statement, Chris, because it was almost pretty much identical to the last, the last statement with a few, few minor changes, but the RBA seems very reluctant to give any sort of forward guidance away. What were you sort of seeing?
Speaker 2:Yeah, I thought when I actually first started reading that meeting note that I was actually reading the one from last month and I had to just double check that I hadn't clicked the, the wrong thing, but certainly what they're saying looks very consistent with what they said last month, that they're still hiking rates and that they think they need to take it higher. So it was a little bit surprising. I think that, you know, they, they set us up with this language about the narrow path and, you know, having to navigate potentially a slower economy and things like that. And even with that, they've hiked another 50, you know, as you said, making it the fastest that they've done and you know, what looks to be like, they're getting ready to go again next month as well.
Speaker 1:Yeah. It's certainly hard to take them at, uh, face value that they're not on a preset path when they've done five hikes in five months. You'd have to be a fairly, uh, cautious man not to get that. They might go six and six given, you know, their previous path. But, um, you know, they're trying to tell us that they're not on a preset path, but you know, I just find that given their actions difficult to believe.
Speaker 2:Yeah. And you know, I think it's also interesting when you look at that, you know, usually when they describe monetary policy, they say that it works with a lag. And if you kind of look through some of the prior statements, they say things like a long and variable lag in this statement. What they've said is that the full effects of the, the prior hikes haven't even been felt yet. So the fact that they're saying we need to do more as the past ones haven't been felt, and you're not saying you're on a preset path, it is kind of starting to become, I think a little bit odd. I would've thought that they could, you know, take five seconds to, to just see what they've done, but it doesn't look like that's what they're, they're thinking at the moment.
Speaker 1:The one thing that sort of sticks in my mind is that if you're not gonna wait and see what the impact and to see whether you're doing your damage, why eek it out like this? Why do five by, um, five increases? You could have just put the cash rate up to and a quarter percent in one go and had exactly the same impact because they're not waiting to see whether they're doing any damage at all.
Speaker 2:Yeah. I hadn't really thought about that. That would've been a, an interesting one if they just whacked it up too, but I guess the timing that it takes to flow through, it's not gonna be that different. I mean, to kind of that end, there was a report from CBA just yesterday, which said that usually takes about three months for the, the hike to flow through. So the fact that we've now gone five in five months, we've only really seen the first two turn up in the consumption figures and what people are paying. So, you know, as what you said, they, they probably could have done too. It would've been a bit odd, but if they're gonna keep marching it higher, I think the outcome's gonna be exactly the same as if they had have done that.
Speaker 1:Yeah. I mean, we we've seen, you know, what we said is probably the, literally the, the fastest rate hiking cycle ever in, in magnitude, it's probably now the second highest, um, given sort of the three hikes in four months back in 94, but they, they were much bigger magnitude, but I guess the other difference is, you know, for, we've gone from pretty much the point where now most people's home loan rates will have doubled and, and you know, we've never really seen that before. Uh, I know the magnitude of the interest rates is still is still less than what we've seen in past cycles, but, you know, we, we keep talking about this, the debt loads now are much higher. You would've thought some caution might, might have crept into the RBAs, uh, sort of thinking, but, but they don't seem to be the slightest bit, uh, concern.
Speaker 2:Yeah, certainly not yet. I, I think when you kind of look at, you know, what you said about rates rising at their fastest paces, if you look at say someone who borrowed money yet 2%, which was, which was basically the lows of where the market got for the, for the variable rate market, if you borrowed money at the back end of 2021, then you're gonna see your repayments go up by about 40 to 50%, uh, after this one. So it is kind of starting to hit a pretty sizable chunk. And if the housing market keeps falling, you're gonna have people who potentially have houses, which are almost probably a hundred percent LVR at a period when their mortgage repayments are going up by 40 50%. So I think at, you know, some point in time over the next 12 months, we probably will start to see a certain segment of the housing market, enter some stress.
Speaker 1:Yeah. It's something we, we look at a fair bit and, you know, I think a lot of market commentators and the RBA are a bit disingenuous and that they talk about averages all the time. You know, the average borrower is not that much worse off the average mortgage market is okay. But, you know, realistically, if we had higher unemployment, I'd probably be more worried. But the fact that it's really the worst 10% of mortgages is, is where the, the problems are gonna start to appear in, um, you know, problem areas. So, you know, I think that that really is what worries me. And if you then get what they're now expecting is a, a tick up in the unemployment rate, if that coincides with those same people that are on a mortgage stress, it could get nasty very quickly.
Speaker 2:Yeah. I, I think something else that always sits in my head when I kind of think about these things is there was a comment a long time ago from Ray Delio that he said one person's borrowing is another person's income. So you can look at this and say, well, you know, as long as the unemployment rate doesn't rise, you know, most people will be fine and they continue paying their housing. But if you have a shock of, you know, 50% to your repayments on your house, then you're gonna have to reduce your spending elsewhere. So at some point in time, unemployment probably really does need to slow. And that's the point in time when you'll probably start to see more of this, this stress potentially turn up. But again, you go back to the fact that, you know, it takes three, three months for this to flow through. You haven't even really seen any of the effects yet. So it's a bit too early, I think to say, well, there's not gonna be an unemployment effect because it, it hasn't had a chance to occur yet.
Speaker 1:We've sort of been on record sort of saying, we think, you know, this cycle is probably gonna be a little bit different in that we're probably not gonna see large numbers of defaults, but you know, where the impact is really gonna come is obviously in spending on, on other areas. I mean, people will generally pay them mortgage rather over everything else, but will we start to see stress in credit card lending? Will we start to see stress in, in automobiles, those kinds of things. So they're the other things that we probably should be keeping an eye on, not just fixating completely on the housing market, Chris, we, we, we are actually starting to see house prices decline. I won't say rapidly, but they're certainly compared to the last few years have, have been reasonably quick, particularly in Sydney and Melbourne less. So in some of the other states, the market seems pretty much in two camps either. It's the worst thing that could possibly have happened, or we shouldn't worry about it because, you know, house prices have already gone up a lot over the last, um, two years, particularly since the pandemic started, you know, what are your views on the current pace of house price decline?
Speaker 2:If the, you know, the pandemic kind of showed us anything, it was that, you know, housing obviously is the most rate sensitive market that we have to have. The gains that we had when, you know, unemployment was, was the way that it was kind of in 2021, I think says that there's this, this huge ability of rates to move the housing market. The interesting thing that I see here is that the pace of the declines is starting to pick up. So it's not just that the housing market is falling it's that we're getting bigger and bigger falls as it comes. And I would expect that continue to continue as long as they keep putting rates up. So, you know, if you were to kind of draw some lines on a chart and try and figure out what could occur rates are now higher than they were in 2018 and in 2018 house prices were about 20, 25% lower from here, given wages haven't really moved that far over the past four years, you could pretty easily see a 20% decline occur if they continue pushing rates up for people who bought five years ago, that's fine. But for people who bought in Sydney over the past 12 months, you know, that could be for some people close to a million bucks. Yeah.
Speaker 1:It's certainly, uh, not an equal, um, problem for, for people. And I think that that's one of the things that's hard to sort of comprehend. Some people are gonna feel a significant amount of pain, and some people won't feel much at all that that's adds, I guess, to some of the problems that the RBA has in that, you know, inflation tends to be affecting everybody at the same time, whether the house price, stress doesn't. So you can sort of see why the, the RBA is a little reluctant to give too much forward guidance, um, or to put too much emphasis on the housing market. But I guess the one thing we keep coming back to is when we look through past periods, the housing market has really been the thing that the RBA has responded to as much as they say they haven't. Um, when the housing markets become under stress, that that's been the trigger for them to either stop hiking or, or to actually start easing again. And I guess, you know, that that's where we, we keep coming back to and, and why we think house prices are so important. You know, there are other things in the economy too, that, that aren't looking real flash as well, but, you know, housing to us is still really the, the key indicator.
Speaker 2:Yeah. It, I, I would say it's probably also more about kind of the flow through effect that it'll have. So, you know, you kind of hear people say as well, for those who have savings and pensioners and stuff like that. Well, the, the deposit rate's gonna be higher so they can spend and more, that might be true, but housing is the biggest asset in Australia. I think it TA it makes up about 80% of household wealth. So the drop in housing can very easily offset the, you know, one, 2% increase that we've seen in the deposit rates. But then the other thing is you're starting to see these construction companies go under, you're starting to see building approvals drop. You're probably gonna start to see potentially some of these investments really needing to, to come onto the market and find a renter in them. If you've been kind of sitting on your hands and waiting. So it's not just the prices. I think that's gonna be the problem. You're gonna see other bits and pieces flow through. And, you know, maybe we're now in an environment where the economy can withstand that. But if you were to go through history and look at, you know, 20% declines in the house price, you wouldn't be expecting a very strong economy to come off the back of that.
Speaker 1:Yeah. It's certainly getting into territory we haven't experienced before. So it's easy to sit here and commentate on it, but I don't think anybody really knows what happens if we, we suffer a significant decline of 20 or 25% in house prices, cuz for the most part, at least, you know, in most of our lifetimes it hasn't happened. So I think it is still a fairly large risk. I think on the other side too, we, we always talk about wealth effects. You know, they're a positive multiplier when, when prices are going up, whether it be equities, housing, things like that. If you do get those wealth effects, you would expect it to happen in reverse as well. So if, if people aren't feeling quite as rich as what they were, you get impacts going back the other way. And again, they're the things I think most people aren't really factoring into, you know, their straight line calculations. If, you know, we pay more for our house. If we're paying more for inflation, if we drop, you know, it only has its impact, but there's all these other things in the background that we haven't really started to factor in yet.
Speaker 2:Yeah. And I, I think when, you know, when, when we look at this and when we look at, for example, what the RBA is doing, what versus what the Fed's doing, this was part of the reason why we thought the RBA would be slower than the federal reserve. So the, the mortgage market in the us is a, is a fixed rate market. It's usually lending for about 30 years. So if you borrowed money and you know, bought a big house last year, then you're just gonna sit in it for the next 30 years and not refinance. So in essence, those borrowers are probably gonna be okay, whereas in Australia with the variable market, it it's gonna start hitting those people that have borrowed too much, much faster than, than overseas. So that's generally why when, when I look at, at what's going on, you can kind of, I think make an argument that the fed can continue to be aggressive, but for the RBA, they should be looking what the effect is is doing. Because those people who borrowed last year are being repriced pretty quickly. Whereas in the us, it's gonna take some time.
Speaker 1:Yeah. And I think one, one of the other things too, is that, you know, we've already moved a long way. Yet markets are still pricing in even more hikes on top of what we've already seen, you know, anywhere between, you know, 150 to 200 basis points of hikes. You know, if we're starting to see some of these stresses appear now haven't helped the market. If, um, you know, we get to, to get to 400 basis points of rate hikes. So it it's gonna be interesting. I mean, the RBA is certainly not gonna rule out hiking rates. They would never, they would never do that because, um, it would limit their, their policy options. But, but you have to think that they are getting close to a point where they're at least gonna pause.
Speaker 2:Yeah. I, I was actually kind of hoping that we would see some language that they were gonna pause. And that's why I was so shocked that, you know, the statement was essentially exactly the same. I actually felt like they paired back some of the caution that they had in there from last month. And, and it kind of looks like it just smells exactly the same that we are ready to go again and, and we'll figure it out later. So it, it is becoming, I think very interesting because when you look at the stress test that the RBA did back in April, just before they started hiking, they checked what a 2% increase in the cash rate would do to the mortgage market. And so when they did that, they said about 20% of borrowers would see a 40% increase in their payments. Now, if you add an extra 2% on top of that, then you know, my expectation would be that we'd see about 40% of borrowers have a 40% increase. So even the stress testing that it looked like they did, you know, just five months ago can pretty much be chucked out the window because we're through that. Now
Speaker 1:The one thing that I also sort of read into the statement is that for almost every negative that they counted with a positive, my feeling was that some of those positives were much more domestic focused where the negatives were probably much more overseas focused. We, we saw the RBA, mentioned the slowdown in China, which is something we've been talking about for quite some time that seems to be gaining some momentum, but the other, the other big one is, is obviously what's happening in Europe. You know, energy prices in Europe are, are just out of control. That's gonna continue to put pressure on inflation globally, but, but especially in Europe, you know, we, we're starting to see global PMI fall. Most of them are not quite contractionary, but they're getting into contractionary territory. Will it matter if we have positives in the domestic economy, if we keep seeing these really big impacts coming from offshore,
Speaker 2:If you look in the statement, the second paragraph that they start with says the outlook for the global economic growth is deteriorated due to pressures on real income. Uh, the tightening of Mylan cherry policy Russia's invasion of Ukraine and the COVID containment measures and other policy challenges in China, when they refer to Australia, they just, they have a different statement that says the Australian economy is continuing to grow solidly and national income is being boosted. What you point out there that they seem to be focusing offshore as the risks and domestic as quite strong is certainly there. Personally, when I look at this, I kind of look at some of these countries and kind of even wonder what they're they're doing and what they expect it to achieve. If you take Europe, for example, and you say, you know, inflation, there is running very high and we need to hike interest rates. Well, we know that's because of the energy prices and the shutoff of gas that they've had. So I don't really understand if you think of, you know, inflation as demand and supply what rates is doing to either of those, you're not gonna move demand because they need the energy and you're not gonna move supply because you're stuck at log aheads with the, the Russian situation. So moving rates there, I kind of see as probably just perpetuating the problems that they have and if that were to occur, you know, you kind of think back to most periods over the past 10 years when rates have dropped, it's usually been because there's been some problem in Europe, that's kind of cascaded into other markets. I think the risk is there now that all central banks are hiking, that something from the left field will come, but what time that comes and when it comes is very hard to kind of understand because it, it kind of looks like inflation is just moving higher and rates probably don't have much of an effect in some economies. So, you know, that's gonna cause some troubles and, and how the RBA deals with that. It is essentially saying, you know, on one hand we weighed up positively. And on the other hand, we weighed up as negatively.
Speaker 1:Yeah. I think one of the other really interesting things, and again, I don't really know how it's going to balance itself out, but in those economies, you, you have central banks wanting to tighten interest rates. But on the other hand, high energy prices are leading governments to do stimulus measures. So you've got, you know, the UK government and you've got several other European sort of governments who are now coming out with policies to try and ease some of that pain, either through price caps or through direct measures to sort of help consumers, even in the us, you, you have some of VI policies where he's actually forgiving debt. Now, debt forgiveness in itself probably doesn't have a stimulatory effect. It probably just has a budgetary effect, but there's certainly now some evidence that governments are sort of trying to step back from some of these policies and again, cushion some of the blows. So I dunno whether that makes it harder for central banks or, or easier in the long run, but it's certainly an interesting behavioral pattern that the, the people who ultimately need to get Revo into office are, are trying to offset some of the pain for, for consumers.
Speaker 2:Yeah. And you know, it, we're probably not at that point yet where the politicians are becoming concerned, but, you know, I would think if house prices continue dropping in Australia, then that's probably not a good position to be in if you're a politician. And that means you're probably gonna have to try and give some benefit back somewhere else, which then becomes inflationary again. So, you know, we talked about this probably six to 12 months ago that the policy aims of the central banks and the central and the, the government don't seem, seem to be aligned. And they still don't really seem to be aligned because if you're gonna follow through with these policies of making it tougher for everyone, then that's not good if you're a politician. And you're probably gonna be trying to think of ways to give money out or, you know, cancel debt like, like Biden's done or just do something that keeps people happy. So, you know, there, there might even be this push and pull of, you know, inflationary policies coming from the government, trying to be offset by, you know, restriction policies in the central bank.
Speaker 1:Well, that's it for the month, if you ever wanna suggest topics or discuss anything further with Chris and I, we can be contacted at the rate debate@yaracm.com. So tune in next month, when we deliver our latest thoughts on the RBAs October rate decision and provide an update on what's been happening in markets until then stay safe.
Speaker 3:The rate debate podcast content may contain general advice before acting on anything in this podcast, you should consider your own objectives, financial situation, or needs and seek the advice of an appropriately qualified financial advisor.