‘Nasty phase’ of house prices could see them fall by 20 per cent

House prices are falling – and Australia is in phase two of a possible three phases. If we enter phase three things could get “nasty”.

Australians will by now all be familiar with falling property prices. Especially in Sydney and Melbourne where the bust has been underway longest. It has now spread everywhere.

How far are property prices going to fall?

There are generally three stages to any property bust.

Phase one: The first is the tightening of monetary policy. This could be because the central bank has lifted its cash rate. Or, it could be because of an external shock to the banking system.

As interest rates rise, the amount that new mortgagees can afford to borrow begins to fall. This leads to a lower marginal bid in property prices and they roll over.

Phase two: The second phase is psychological. As price falls spread, buyers begin to retrench, and the volume of transactions falls away. For while, we see a standoff between sceptical buyers and grumpy sellers until the latter capitulate.

So far this process is an orderly correction and can take prices down by 10 per cent plus. This is the kind of correction Australian property has seen repeatedly in 2002, 2008, 2012, and 2018.

Phase three: But, there is a third phase that has overtaken other markets if not Australia’s. It is when the price falls move towards 20 per cent. If the credit that was extended to generate the boom was poorly managed then such a magnitude of asset price falls is large enough to cause macroeconomic and financial instability.

For example, this is where New Zealand finds itself today. Its pandemic property boom was large and the bust is proving to be just as big, already down 13 per cent with interest rates still rising and the central bank forecasting recession.

It is quite conceivable that this bust will turn unruly, credit be rationed by banks and the recession be long and deep as household and bank balance sheets are forced to retrench for an extended period.

In turn, unemployment will then spike higher and property sales become forced by inclement economic circumstances.

New Zealand is already flirting with these outcomes and, if they transpire, it could unwind all pandemic property price gains, around a fall of one-third.

Is Australia the next New Zealand?

There are reasons to be concerned that Australian property will follow New Zealand into the nasty third phase.

The Australian boom was also large. The rise in credit was equally sharp and Aussie households are even more indebted than Kiwis. As well, both markets are undergoing very big mortgage rotation shocks, stepping up from very low fixed rates to very high.

Half of New Zealand mortgagees will jump from 3 per cent interest rates to 6.5 per cent in 2023. In Australia, the number is more like one quarter but that is still formidable!

Australia does have a few advantages to avoid the third phase of a property disaster.

After a decade of near misses, Australian banks have been forced to hold more capital to absorb losses.

Australia has been lagging the post-Covid global economic recovery by a few quarters owing to our extended lockdowns so households still have considerable savings to absorb the rates shock.

The economy has also been a huge beneficiary of the Ukraine war, largely via soaring coal prices. This has dramatically boosted the budget so there is headroom for fiscal stimulus.

Importantly, the same fiscal repair stands as a guarantee for the banking system. This ought to keep markets from repricing funding for banks so there is not likely to be out-of-cycle pressure to raise mortgage rates independently of the central bank.

Unemployment is low and local inflation is still largely in goods, which is imploding worldwide. A tsunami of goods deflation will arrive here in due course. So long as the Albanese Government prevents the gas cartel from rorting us all to death with utility bill inflation.

These factors all mean that the Reserve Bank is almost, if not already, done hiking rates.

A historic bust but no phase three for Australia

So, the base for Australia is that house prices keep falling for much of 2023. This will be the largest price bust in modern history. Somewhere in the vicinity of 15 per cent seems about right, with the eastern cities leading at closer to 20 per cent peak-to-trough falls.

But, on balance, we are likely to avoid the harder landing scenarios of a 20 per cent plus house price correction.

Rate cuts later this year will put a floor under prices. And, thanks to the revival of mass immigration, 2024 looms as a return to the bad old days of crushed wages and rising house prices.

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geopolitics and economics portal. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

Originally published as ‘Nasty phase’ of house prices could see them fall by 20 per cent