Feature Stories | Sep 29 2022
The US Federal Reserve’s policy aggression will force the RBA into further rate hikes that will potentially lead to a bigger house price fall than previously feared.
-Fed hawkishness shakes up global central banks
-Chance of RBA slowing down has receded
-Morgan Stanley forecasting -20% fall in house prices
-Will Australia see a recession?
By Greg Peel
Following the July Federal Reserve meeting, Wall Street sensed a slightly more dovish tone to Jerome Powell’s rhetoric, leading to the assumption the Fed would at least begin to slow the pace of rate hikes, or even pause, and perhaps “pivot” (cut rates) in 2023. As a result, the S&P500 regained 50% of what it had lost year to date.
It would appear Powell was rather incensed by this interpretation, if the implicit rebuke Wall Street received for this misguided view at Jackson Hole in August is anything to go by. Wall Street turned and began falling back again, expecting further excessive rate hikes. When US August inflation data shocked to the upside, Wall Street tanked, then headed to new 2022 lows.
As a result, economists have scrambled to upgrade their expectations of the Fed’s “terminal” rate target – the rate at which the hikes would stop. At the September meeting, FOMC forecasts suggested that rate would be 4.6%, up from the 3.00-3.25% rate suggested previously, following another 75 point hike.
Economists have also lifted their expectations for rates in Australia and across the globe.
The Fed has led the monetary policy aggression as it seeks to crush inflation, as evidenced in a surge in the reserve currency to twenty-year highs. While other central banks have also been raising rates to curb inflation, they are now forced to also step up the aggression to keep pace with the Fed, lest their currencies collapse and even more inflation is imported.
Witness the UK pound, which had fallen to its lowest level ever against the US dollar, prior to Bank of England intervention, following a shock policy release from the new government which included tax cuts and a spending bonanza despite an already huge budget deficit, intended to save the UK economy.
These fiscal policies only put more pressure on the Bank of England to hike its cash rate.
NAB economists have raised their Fed terminal rate expectation to 4.00-4.25% from a prior 3.50-3.75%, bringing it in line with general market consensus post the September Fed meeting.
Westpac economists expect 4.125% (midpoint of 4.00-4.25%) by the end of this year.
Barrenjoey economists see 4.25-4.50% by year-end, and another 25-50 points of hikes in early 2023.
ANZ Bank economists are forecasting a Fed terminal rate of 5.0%.
“Our new 5.0% peak for the fed funds rate is substantially restrictive, raising the risk of a harder landing for the US economy. These risks are even higher given central banks have allowed policy to disconnect from economic improvement over 2020 and 2021. Opportunities to pause hiking to assess the impact of already delivered interest rate increases are limited.”
While 5% may be considered an outlier among forecasts, there is agreement among economists that because the Fed was so slow to react to surging inflation, it has to go hard and go fast to catch up. Given the impact of rate hikes typically filters through the economy with a lag of six months or more, typically a central bank would pause to assess that impact before making the next move, but the Fed does not have that luxury.
Many fear, nonetheless, the Fed will go too far, too fast, and will be forced to cut rates later in 2023 in the wake of a deeper US recession than feared. While the Fed appears to have abandoned hope of a “soft landing” – Powell warning of “pain” ahead – the FOMC will still want to keep that pain to a bearable level.
And the RBA?
If the Fed hikes, the RBA has to hike too. Already the Aussie dollar has fallen to 2020 covid lockdown levels.
However, the Australian dollar has only fallen against the US dollar, and is higher against other currencies. This, suggests Barrenjoey, should mitigate the impact of imported inflation.
The RBA’s cash rate is currently 2.35% compared to the Fed’s 3.125% (at the midpoint). While this might imply the RBA had better catch up fast, economists agree demand- and wage-pull inflation pressures are materially lower in Australia.
While it’s back in the mists of time, the last Australian headline CPI reading was 6.1%, and the RBA is forecasting a peak of 7.75%. The US CPI peaked at (we assume) 9.1% in June and was 8.3% in August.
The impact of higher rates on households is also different in Australia compared to the US. The bulk of US mortgages are fixed for 10-15 years. The bulk of Australian mortgages are on variable rates, and those that are fixed are only 1-4 years in duration. The RBA thus knows it has to tread carefully, hence the board considered only a 25 point hike in September before settling on 50.
It was then expected perhaps October would only bring a 25 point hike, but that was before US August CPI result and the September Fed meeting. Most economists now expect another 50 points in October.
Barrenjoey expects 50 points next month followed by 25 in each of November and December and a pause in February (the RBA does not meet in January), taking the terminal rate to 3.35%. ANZ Bank also forecasts 3.35%, but is “considering whether additional hikes beyond our peak forecast might be required”.
Morgan Stanley expects 50, 25, 25 and another 25 in February, and has raised its terminal rate forecast to 3.6% from 3.1%.
Morgan Stanley had forecast the Australian CPI to peak at 7.4% in the December quarter but now has 7.8% (RBA 7.75%) on higher energy costs. The economists’ 2023 forecast has been lifted to 3.9% from 3.4% as higher rents and wages are passed through. The forecast is for the core rate (ex food & energy) to peak at 5.9% and fall to 3.9% by end-2023.
While high inflation and RBA rate hikes clearly weigh on household budgets, the other factor is what the impact will be on house prices. On that matter, Morgan Stanley has made rather a big call.
Look out below
Housing matters to the Australian economy, notes Morgan Stanley. Housing makes up 68% of household sector net wealth, worth $10trn or 700% of annual household disposable income.
Relatedly, household debt sits at 185% of income, one of the highest leverage rates in the world, and importantly the majority of this is at variable interest rates. Construction contributes 7.5% of GDP and 9% of employment, with its cyclicality meaning its growth contribution is often even larger. All this makes the outlook for the housing market a key swing factor for the economy, in Morgan Stanley’s view.
Morgan Stanley is not alone in that view.
One might argue that if the value of your house falls, it’s really not an issue as long as you can pay the mortgage. Assuming you’re planning to stay for a while – maybe for the rest of your lucid days – house price fluctuations are not important.
But the issue is the psychological impact of the so-called “wealth factor”. Whether logical or not, homeowners feel richer when house prices rise and are thus more inclined towards discretionary spending, and poorer when they fall hence households tighten their belts. Of course, there is a logic in increased equity in a home providing a wealth buffer which diminishes when prices fall.
Morgan Stanley now expects Australian house prices to fully retrace their post-covid boom, falling -20% nationally from peak to trough, from a prior forecast of -15%, having fallen -4% to date from the April peak. This downgrade is entirely driven by a much higher interest rate path assumption relative to when the economists’ prior forecast was set in May.
If prices do fall -20%, Morgan Stanley notes it would be the largest nominal price decline in at least the past 50 years and more than twice the size of the prior largest correction (-10% in 2017-19, when APRA was tightening lending standards), and comparable to what the US suffered (-19%) in the GFC from 2007 to 2012.
The RBA does not officially forecast house prices, although Philip Lowe recently said he would “not be surprised” by a -10% fall. While Morgan Stanley foresees a fall comparable to the US in the GFC, it expects it to be much faster than five years, and it comes with much larger equity buffers (given the size of price rises to date).
What will this mean for the Australian economy?
The flow-through impact of a -20% price fall to the broader economy may nevertheless be slower to emerge than in past downturns, Morgan Stanley suggests.
Thanks to highly competitive banks lowering their fixed mortgage rates to below their variable rates when the RBA cash rate was 0.1% and not expected to increase before 2024, there is a higher proportion of fixed rate mortgages than usual. This does represent an increase of around 75 basis points to the average mortgage when the majority roll off next year, Morgan Stanley notes.
Harking back to the 2019-20 bushfires, and a string of floods in the past two years, there remains a strong pipeline of work to be done. This could mitigate the construction impact, hence Morgan Stanley assumes a broadly flat dwelling investment profile in contrast to the usual cyclical dynamics.
An elevated household savings rate and accumulated housing equity slows the pass through to broader spending (the wealth effect). These factors mitigate the near-term economic slowdown, but don't avoid it, Morgan Stanley warns, given the extent of interest rate increases.
The mitigating factors are also temporary, and don't point to a structurally greater capacity of the economy to absorb higher rates.
Another mitigating factor is migration. Migration has begun to recover after international border restrictions were fully eased earlier this year. On top of this, government policy has focused on accelerating this recovery.
Morgan Stanley thinks the combination of these factors means net migration in 2023 will not only recover, but exceed pre-covid rates, and has raised its annual forecast from 250k to 325k.
This supports GDP growth and eases near-term labour supply issues, but given new migrants don’t typically rush out and buy a house on day one, sustains tightness in the rental market. Rents are a core factor in CPI measurement, and are “sticky” – quick to rise but slow to fall.
Despite the mitigating factors of migration, household equity and excess savings which should slow the pass-through of lower house prices to the broader economy, Morgan Stanley still sees higher rates and a deeper housing market correction leading to more slowing in demand next year.
A Recession?
Morgan Stanley doesn’t see the Australian economy contracting, maintaining an above-consensus 4.1% GDP growth expectation for 2022, while lowering its 2023 growth forecast to 2.1% from 2.3%.
However, given a stronger migration profile, the economists do see a per capita GDP growth recession defined by two quarters of negative per capita growth through the first half of 2023. In other words, Morgan Stanley sees a productivity recession, and forecasts unemployment to rise to 4.2% by end-2023, up from a prior forecast of 3.9% (current 3.5%).
The feature of the Australian economy in the June quarter this year was strong household spending, not on goods, as they were all acquired in the prior two years, but on services missed out on in those two years, such as travel, entertainment and dining.
The Australian economy grew by 0.9% in the June quarter, a solid outcome. But Westpac has a downbeat view on prospects for 2023, with output growth forecast to be a well below-trend 1%, slowing sharply from an expected 3.4% this year. By 2023, the full impact of the RBA’s 325bp increase in interest rates will be felt (Westpac’s forecast), along with the adverse effects of ongoing high inflation.
By next year it is assumed the pent-up demand for services seen this year will fade. Consumer spending is expected by Westpac to be a tepid 1.2% in 2023, while home-building activity will likely contract associated with a sharp pull-back in property prices.
From a global perspective, notes ANZ Bank, the experience of the US – and other economies including the UK, Australia, New Zealand and Korea – is that rate hikes have had much less impact on labour demand than was expected.
Housing indicators have weakened in line with higher rates, but outside China there has been no general increase in unemployment rates or decline in job vacancies. This is good news for people, but a challenge for inflation and monetary policy, ANZ notes.
ANZ’s growth forecasts for next year have been revised down. The economists are forecasting a recession in the UK, and with near zero annual growth in the US and eurozone, shallow recessions are part of the profile now.
A delinquency cycle is likely, ANZ warns. Those businesses that have been reliant on the post-GFC low global interest rate structure are likely to present particular risks.
China remains the main exception to the reliant economy and strong inflation narrative, ANZ asserts. Monetary easing has become ubiquitous as headwinds have increased.
An economy growing at 3% this year and 4.2% and 4.0% in the next two years would be the three weakest years (outside 2020’s covid crisis) since the 1970s. China’s external accounts, with seven consecutive months of debt capital outflows, suggest much more hesitancy from foreign investors towards China as an investment destination.
Of course Australia’s economy is inexorably linked to China.
Barrenjoey’s modelling suggests another 100 points of rate hikes from the RBA will drive the Australian economy into recession – with weaker consumer and dwelling investment than currently forecast. Given that, and as the data confirm rapidly weakening domestic activity, Barrenjoey expects the RBA will start an easing cycle in the December quarter 2023.
This should be sufficient to leave any recession as relatively short and shallow, the economists suggest, and perhaps that is what is needed to cement the path back to 2-3% inflation.
A narrow path has just become even narrower.
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