The pain of being maxed out

The next three years will be tougher for the Reserve Bank than the pre-GFC period, with a highly leveraged economy and low domestic demand growth limiting the levers at its disposal.

All is hunky dory again with the US government and its debt repayments.

Here in Australia, markets are pricing rate hikes ahead. Today Glenn Stevens is expected to signal the worst is behind us, reinforcing that we are indeed on the precipice of monetary tightening cycle.

But the next three years will be no picnic. Our probable inability to really ramp household leverage up from here and the risks to mining expenditure and iron ore prices as new supply comes on stream are bigger challenges than property values.

The current easing cycle has seen 225 basis points lopped from interest rates since November 2011 over eight cuts, mimicking the easing spree of 2001 when 200 basis points were sliced off the official cash rate over six cuts from February to December. What followed was a slow package of 12 increases of 25 basis points each between May 2002 and March 2008.

But there are some glaring differences between now and 12 years ago that will make life tougher for Reserve Bank governor Stevens and his colleagues.

Back then, policymakers had freedom from asset-price bubbles in housing, or indeed in equities after the bursting of the tech boom. China’s economy was accelerating, commodity prices were rising and the currency was tanking.

Most significantly, leveraging was a fraction of current levels. Australia now boasts a household debt-to-GDP ratio among the top five in the world. And this time China’s boom is slowing and there has been no bursting of a bubble in housing or equities yet. The currency is stubbornly strong.

Just like in 2001, the Reserve Bank is looking to limit the damage from rising house prices.  But it’s not so simple now as the leverage levels are so very high. Offshore leads are also too vague to support a local rate hike yet, with the latest Beige Book showing US home buyers are baulking at rising mortgage rates. The Fed has so far only talked about tapering its monetary stimulus.  It’s all words and no action.

Unusually, Australian 10-year bond yields are up even as US 10-year yields have fallen.

“This is a very rare occurrence so clearly people are starting to think that the Stevens put, as it were, may be taken off the table here.  The Reserve Bank has come out and said that it’s not committal on rate cuts or rate hikes,” says Credit Suisse strategist Damien Boey.

With consumers “kind of tapped-out now when it comes to leverage and borrowing,” Australia would be doing well to keep household debt-to-GDP levels flat for the next 10 years, let alone increase leverage, Boey says.

“We need to be downgrading Australia because it’s just population growth driving the economy. That’s not driving a lot per capita,” he says.

Cash buyers of property, notably wealthy immigrants from Asia, have brought a stealth form of deleveraging. But it is arguable that for the next few years retail sales growth will only be in line with population growth, and domestic demand growth in real terms will be close to zero. It’s not an environment supportive to rate hikes.

There’s been a lot of talk about how there is (and how there isn’t) a house price bubble. Affordability is a binding constraint so it should be enough for the Reserve Bank to just chin wag. This high level of debt, and rising house prices themselves, will self-regulate the property market as it will become prohibitive for many. Job security levels are also not supportive of taking out big mortgages.

Housing credit rates are still subdued, with housing finance for new dwellings only up one per cent year-on-year and finance for new home buyers down 10 per cent (Why the housing boom is difference this time, October 11).

With the strength of US economic growth in doubt, fiscal austerity an issue and the latest political stalemate unsettling punters across the globe, there is not a lot of offshore imperative to tighten monetary conditions here.

It is hard to see household debt ramping up significantly when mortgage rates of around at 5 per cent and average net rental yields of 2.5 per cent put affordability for borrowing at 50 per cent. The actual average is already about 60 per cent.

“They are not making money. They are relying on house prices to go up – a big ask in this environment when house prices are very expensive by international standards and we’re very highly geared,” says Boey.

For the banks, the cost of capital is still a problem, with the total cost much higher for the lender than a decade ago. While banks cut fees and other costs in an apparent frenzy of competition, that has eased off as the banks face less pressure from onerous rates on term deposits.

“It’s still an oligopoly,” noted one banker, who says the big four are taking a three-month wait and see on rates.

Getting such loan-fatigued consumers to take over the mantle from mining and reignite economic growth is a challenge never before faced by the central bank. And with the cash rate already 225 basis points above the US and the Australian dollar entrenched in the mid 90 US cents, the Reserve Bank doesn’t appear to have a whole lot of wiggle room for tightening – at least until the US Federal Reserve makes good on its tapering tease.

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