Unfortunately for the RBA’s bosses, their own boffins have now debunked their junk. In an outstanding new paper two RBA economists conclude that the “reduction in real interest rates [effected by the RBA] accounts for most of the subsequent boom in dwelling prices” since 2011.
The authors, Trent Saunders and Peter Tulip, find that a one percentage point fall in real interest rates boosts Aussie house prices by 17 per cent based on the assessed cost of owning a property between 1987 and 2018. Yet as interest rates approach zero, the sensitivity of house prices to changes in the cost of capital escalates.
Based on current ownership costs, Saunders and Tulip estimate that a one percentage point drop in expected real mortgage rates would inflate house prices by an enormous 28 per cent over the long run.
Before RBA ignited the recent boom, the 10 year government bond yield was around 4 per cent. Today it has slumped to less than 2 per cent. The RBA’s research implies that should have increased house prices by roughly 40 per cent before inflation, which is almost exactly what we got. Put differently, Saunders and Tulip find that the RBA’s cash rate cuts since 2011 have forced up house prices by an enormous 31 per cent above the growth in real household incomes.
If the RBA bequeathed the bubble, it was APRA who saved us by deflating it in an orderly fashion with an unprecedented series of constraints on new credit creation and a unilateral tightening of lending standards that compelled banks to hike rates on investment and interest-only loans by between 25 and 50 basis points.
Acknowledging these insights is important in the context of the feverish speculation that the RBA will get the yips from its long-held position that the next move in rates is up. There is a consensus that the RBA will once again debase the price of money as a result of declining house prices putting downward pressure on consumption and growth even though Australia’s jobless rate is at a historically low 5.0 per cent level that the RBA has stated is consistent with full employment.
A more sensible central bank might be concerned that its standard minimum move of two 25 basis point cuts would be capitalised right back into house prices, with Saunders and Tulip’s analysis implying home values will jump 14 per cent (more than negating the peak-to-trough losses recorded in the current correction).
The sad thing is that the housing downturn is the best thing that has happened to the Aussie economy in years because it is cauterising our biggest financial stability risk. The RBA would be better served by tolerating a period of sub-par growth and allowing the housing market to clear.
Bank funding costs
Another reason to pause is that bank funding costs are falling fast after consistently climbing over the last year. The 3 month bank bill swap rate (BBSW) has dropped from 2.09 per cent in December to 1.85 per cent today while the cost of the major banks’ 5 year senior bonds has shrunk from 1.15 per cent above BBSW to 0.95 per cent.
That is, funding costs in wholesale bond markets have compressed by 0.47 percentage points, which means banks could start easing mortgage rates as APRA relaxes its macroprudential controls and competition for loans intensifies. And this process has a long way to run: the major banks’ senior bonds were trading on much tighter credit spreads of just 0.72 per cent above BBSW as recently as January 2018.
Two key catalysts for the credit rally have been the US Federal Reserve’s decision to back-away from its central case of two interest rate hikes in 2019 and the likelihood that APRA’s new “total loss absorbing capacity” policy will disappear about one-fifth of all major bank senior bonds and replace them with bail-in-able debt.
A final influence has been the Fed canvassing the possibility of adopting a brand-new monetary policy framework known as “inflation averaging”, which has massive implications for asset prices. For many years we have argued that central banks would become politicised and relax their commitments to price stability, and this seems to be playing out.
The Fed currently targets 2 per cent core inflation over its forecast horizon, ignoring past outcomes. But because of concerns inflation expectations may be drifting downwards, the Fed believes that it should deliver an average 2 per cent rate of inflation over the business cycle. This means that if it undershoots 2 per cent as it has done since 2007 (inflation has averaged 1.6 per cent), it must make-up for the miss over the rest of the cycle.
So we may be suddenly living in a world where the Fed is targeting a higher circa 2.25 to 2.50 per cent core inflation rate for a prolonged period of time, which is a game-changer. It means that notwithstanding wages growth in the US has surged back to 3.4 per cent, or just below its pre-crisis peak of 3.6 per cent, the Fed may leave rates lower for longer. (Eventually they will have to normalise to higher levels.)
The bottom line is that the search for yield dynamic is back in a big way, which is positive for any asset that offer returns above bank deposits. The flip-side is that this can translate into mums and dads assuming risks they don’t understand.
This is especially the case with the rush of rapid-fire capital raisings via listed investment companies and trusts (LICs and LITs) that circumvent the Future of Financial Advice (FOFA) laws that prohibit payments of conflicted sales commissions to brokers and advisers pushing product to punters.
Given the crazy equity biases in Australian super fund portfolios, which are the highest in the world, and an equally large dependency on cash in self-managed super funds, there is a compelling argument for mums and dads to diversify across a wider spectrum of exposures sitting between cash and shares.
It should be pretty straightforward for an informed retail investor to get their heads around the underlying credit risks associated with buying senior bonds from Telstra, subordinated bonds off IAG, or a hybrid from CBA.
Nowadays there is loads of impressive educational material out there, and none of these assets have anything remotely resembling the pricing uncertainty and volatility of the equities that dominate their portfolios (hybrid volatility is about one-third the risk of lower-ranking shares).
The historically untapped high-yield Aussie private debt market, which was once the exclusive domain of the big banks is, however, much more illiquid and opaque, and requires an expert investment manager with decades of lending experience through booms and busts.
Compared to traditional investment-grade bonds, private loans offer vastly superior interest rates with the trade-offs that they tend to be far less liquid (ie, cannot be easily sold), involve lending to unrated and lesser known companies that would ordinarily get finance from banks, and have a theoretically higher risk of default on a loan-by-loan basis.
Because increasingly tough regulation makes it difficult for banks to lend to some corporates on reasonable terms, there can be attractive opportunities for non-bank private debt players that have the expertise to synthesise and price the complex array of private debt risks.
“We can access particularly attractive risk-adjusted returns on sub-investment grade private debt partly because banks have withdrawn from certain market segments as a result of changes to capital adequacy requirements and increased regulatory oversight in sectors like property,” says the co-founder of private debt pioneer Metrics, Andrew Lockhart.
Much like a private equity investor (or a bank), active managers like Metrics will be intimately engaged with their borrowers. “We have significant influence over terms and structure, and will maintain a close relationship with the borrower whereas in public debt capital markets, structure and terms are more market driven,” Lockhart says.
Another potential benefit is the capital stability that you also see in private equity. The lack of daily liquidity in these assets means they cannot be marked-to-market.
A AAA rated covered bond from ANZ, which ranks above a bank deposit in the capital structure, can ironically have more return volatility than a portfolio of high-yield private loans for which there are no regularly traded prices.
On this note, credit liquidity is generally poorly understood. Most institutional investors confuse the constrained ability of market-makers to inventory bonds on their balance-sheets since the 2008 crisis with poor secondary market liquidity. Yet the latest US Federal Reserve research demonstrates quite the opposite.
Secondary turnover in the investment-grade corporate bond market as a share of all bonds outstanding has consistently increased since 2008 and is now higher than pre-crisis levels. Likewise bid-offer spreads, which exploded in 2008, have trended down for years and are actually now tighter than they were before the crisis. The same is true of market impact costs and new primary issuance liquidity.
And if groups like Metrics continue to liberate the private debt space, you would hope liquidity improves there too. They are certainly well placed to capitalise on the inertia and inefficiency in the Aussie banking system created by heightened regulation and the royal commission.
The trick for investors is to ensure that the investment manager committing to these loans assesses and prices risks as well as the big banks do.