Too many rate hikes will ‘crash housing’: UBS

As recession fears swirl, the housing market’s heightened sensitivity to rate rises suggests the Reserve Bank will stop lifting the official cash rate in November, according to UBS.

The major housing markets of Sydney and Melbourne were even falling before the RBA started lifting rates. Picture: Getty Images

As recession fears swirl, the housing market’s heightened sensitivity to rate rises and the prospect of a significant, albeit lagged impact on consumption suggests the Reserve Bank will stop lifting the official cash rate in November and cut in the second half of 2023, according to UBS.

A few weeks ago the market expected the cash rate to hit 4.5 per cent by mid-2023.

It now sees the key monetary policy rate peaking near 3.5 per cent in March next year.

But even a 3.5 per cent cash rate and the implied surge in mortgage rates would crush the housing market and household consumption, increasing the risk of recession next year, according to the Swiss investment bank’s highly regarded Australian chief economist, George Tharenou.

“We still think market pricing of about 3.5 per cent – if delivered – would likely crash housing, and see the economy nearing a recession,” Mr Tharenou said. The cash rate is now 1.35 per cent.

Currently, the market sees the cash rate at 3.5 per cent from February to December 2023.

But a 3.5 per cent cash rate would probably push the average variable mortgage rate above 6 per cent.

“Interest payments across the economy next year for the household sector will close to double from now,” Mr Tharenou said. “We have never seen such a sharp increase in repayments.

“That really crushes household cashflow next year when you have cost-of-living issues.”

APRA’s mortgage serviceability buffer requires banks to check if new borrowers can repay their loan at 3 per cent above their current rate, or the “floor” rate set by the bank – whichever is higher.

It raised the mortgage serviceability buffer from 2.5 per cent in November due to soaring property prices and ballooning loan sizes. Loan rates above 6 per cent would be well above those at which millions of people who refinanced or got new loans over the past few years were stress-tested.

UBS, Westpac and NAB expect the RBA cash rate to peak at 2.6 per cent around year end.

CBA, the nation’s biggest lender, sees a peak of just 2.1 per cent, barring a blowout in June quarter CPI data at the end of the month, while ANZ sees the cash rate hitting 3.1 per cent by February 2024.

But Mr Tharenou feels the RBA will need to cut in the second half of next year to ward off a ­recession.

Currently the RBA is heading off a broadening of inflation pressures as headline CPI shoots up to levels well above its 2-3 per cent target band and as US rate increases pressure the Australian dollar.

But Mr Tharenou notes a greater than expected sensitivity from the housing market and sentiment. “We’ve seen house prices start to fall immediately on a ­national basis,” he said.

Indeed, the major markets of Sydney and Melbourne were even falling before the RBA started lifting rates.

“So I think this cycle is being quite pronounced and different to past downturns, when you’ve had a period of rising interest rates, which with a lag cause the housing market to roll over,” Mr Tharenou said. “This time around the housing market began to weaken quite quickly.”

In 2017-18 a regulatory tightening of lending conditions was the main driver of a housing downturn after an excessive easing of lending standards. That’s not the case now. But there’s still a very high share of high-risk loans in the system.

“It’s a bit strange to think that, for all of that macroprudential policy tightening that was implemented, we have ended up a few years later with far higher debt metrics and a greater sensitivity of the housing market to rate rises,” Mr Tharenou said.

Average loan size has increased massively in the past few years and income hasn’t kept up. Debt-servicing metrics – in terms of debt-to-income ratios – have soared.

“The thing which suggests it shouldn’t be as bad as it appears is the big increase during the pandemic in pre-payments on the household buffers for mortgage repayments,” Mr Tharenou said.

“The household savings ratio is also a lot higher, so consumers can keep spending, and there are more fixed-rate mortgages which decrease the initial impact of higher rates.”

Consumption may be resilient for the next few quarters despite the housing downturn.

Currently there’s a lot of momentum in the economy, partly because it is about six months behind the global trend of reopening after the pandemic, the inflation impulse came later and Australia hasn’t felt the worst of the global commodity shock caused by the Ukraine war.

“We are just starting to normalise spending levels because we are about six months behind the global trend of reopening, and the same is true for the inflation peak in Australia,” Mr Tharenou said.

So as it considers the trade-off between growth and inflation, the RBA is expected to keep lifting rates for now, particularly as inflation is likely to exceed its forecast peak of 7 per cent due to energy price rises and food price jumps amid supply disruption caused by the NSW floods.

But at year end the RBA may shift its reaction function back to a “forward-looking assessment of the outlook for the economy, particularly the lagged impact of that housing slowdown on consumption,” Mr Mr Tharenou said.

“They want to make sure they contain inflation expectations but there’s a risk of overtightening because the economic sensitivity is much greater due to the variable rate mortgage rate structure.

“The RBA is a bit stuck now because they’ve started this process of normalising rates and inflation will be higher than expected, but after next month I think they slow down and get stopped out by this housing downturn, which really won’t impact consumption until next year.”

Mr Tharenou sees the sharemarket bottoming once monetary policy uncertainty abates and a “downgrade cycle” in earnings has occurred. Monetary policy uncertainty may have peaked four weeks ago.

But the property market could take longer to bottom.

“The house price outlook is at least 10 per cent down over the next year, but to stop a larger fall will require the RBA to shift their policy direction and start cutting next year.”