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If the expectations of financial markets prove true, Australians could be about to face the most aggressive hike in mortgage interest rates seen in more than 40 years.
The Reserve Bank is expecting to raise the official cash rate in next meeting on 7th June.On the back of the fastest acceleration of inflation in 21 years, hitting 5.1% in the March quarter.
Underlying inflation – the measure most closely watched by the RBA – hit 3.7%, climbing above its 2% to 3% target range for the first time since 2010.
And so, the move to hike rates on Tuesday wasn’t overly unexpected… but the reaction from money markets has been.
Money markets fully priced Tuesday’s hike, and from here implied market expectations suggest rates are on course to hit 3% by year end and could hit almost 4% in 2023.
If that trajectory was to play out, mortgage rates would see a commensurate large and aggressive adjustment, with repayments increasing at a rate of knots. It would in fact be the most aggressive tightening cycle in more than 40 years.
We do not expect that this will come to fruition.
This would be an extraordinary feat even in ordinary times – but these are not normal times and there is still a persistent degree of economic uncertainty.
Household sentiment is slipping as the growing pressure on budgets is denting consumer confidence.
Inflation is still impacted by supply chain disruptions, with ongoing lockdowns in China, container shipping distortions, increased freight costs and the like. Then there are surging fuel prices, higher food prices and the knock-on effects of the east coast floods compounded by the crisis in Ukraine.
That’s cost-push inflation. As opposed to demand-pull driven by an acceleration in spending, with wages growth lifting aggregate demand and in turn generating sustained inflationary pressures.
Instead, household budgets will be constrained with real wages remaining in negative territory.
Why rates won’t rise as much as market pricing
The buffers that households have accumulated will underpin the economy, but cost of living has risen and real wage growth remains negative, with higher interest payments dampening household incomes further.
This is all alongside higher fuel prices, rental price pressures and higher food prices.
The major banks are forecasting the official cash rate could hit 1.75% by the end of the year, with most estimating a terminal rate of more than 2% to be reached at some point in 2023.
For existing mortgage holders, housing affordability will get worse over the next 12 to 18 months as repayments become more expensive with rising interest rates.
Further, more than 1.1 million borrowers have never actually experienced an increase in interest rates.
Consumption makes up almost two thirds of GDP and for the many Australians that borrow to own a home their house is their largest asset. If the value of this asset declines, the “wealth effect” kicks in and can see households spending less, weighing on economic growth.
Wages growth – the big if
This dynamic will be offset by the tight labour market, with unemployment the lowest it’s been since 1974, promoting a degree of confidence and job security – and hopefully in turn stronger wages growth, though this is yet to materialise.
How this dynamic plays out will be crucial in determining the quantum of this tightening cycle and there is a lot of uncertainty here.
In New Zealand house prices are correcting despite stronger wages growth and low unemployment. But in previous tightening cycles in Australia an environment of stronger wages growth and a tight labour market did not see house prices falling in response to rate rises.
An accelerated 300-basis point tightening cycle, such as is being priced at present, would give precious little time for the Reserve Bank to gauge how households are faring with interest rate rises.
These factors are likely to play into a more measured approach from the RBA now the tightening cycle has begun. After all, the RBA is attempting to normalise policy from current stimulatory emergency settings, as opposed to putting the economy into to reverse.
The real issue for households and businesses is where interest rates peak
There are some hints that the RBA is now committed to a period of rising rates. Their expectation is that even by the middle of 2024, inflation would still be at the top of the 2% to 3% target range.
But again, it’s likely the RBA will be hesitant to raise rates too far too fast, cognisant that would see fewer people in jobs, wages growth would be weaker and overall economic activity would reduce – an outcome that would not be desirable to the RBA and their full employment objective.
That said, the tightening cycle has begun and aggressive market pricing aside, households are likely to be able to weather a slower tightening trajectory. The economy has strengthened, and the labour market has tightened, and although real wages growth is currently negative, that picture will hopefully start to shift.
According to the Australian Bureau of Statistics, just under one-third of households own their own home outright, another third are renters and of the just over one-third are paying off a mortgage. Those indebted households are in a historically strong position post-pandemic with high savings, surging asset prices and a strong labour market.
Although mortgage debt has risen and incomes have been growing slowly, house prices have been rising rapidly and with historically low interest rates, many have been able to service more debt. The cost of servicing that debt (defined as the percentage of household disposable income going towards debt repayments) has fallen over the last three years.
Indebted households have also taken advantage of falling interest rates to pay down debt quicker.
Through the pandemic households accumulated some $240 billion in excess savings and the RBA’s April Financial Stability Review found the typical owner-occupier borrower is around two years ahead on their mortgage – in 2018 that was only one year. A substantial portion of borrowers will also be insulated from at least the initial increases in interest rates given around 40% of borrowers fixed mortgage rates, though this will change as their fixed terms end.
Every mortgage taken out in recent years has been approved on the basis that the borrower could still service their mortgage with an additional buffer of 2.5 percentage points. This was increased to 3 percentage points in November 2021.
This should mean that most borrowers are well placed to manage an appropriate tightening cycle.
