The Danger of Low Interest Rates

In a recent article in ‘The Weekend Australian’ James Kirby wrote about what he called the big housing market lies. 

The first of these ‘lies’ is that mortgage servicing costs in Australia are reasonable. According to Kirby, Luci Ellis – deputy governor of the Reserve Bank of Australia (RBA) – has said that Australian mortgages are in the “middle of the pack” in terms of affordability (as measured by ability to repay mortgages). Kirby is clear in his rebuke to this reasoning:

But it’s a fallacy. The price-to-income ratio for homes in Australia is soaring. Australians are able to pay the mortgage each month not because their incomes are high but because the rates are so low … The point is our mortgage services costs are reasonable now — when rates move higher, and they can only move higher from here, this line of thinking will be revealed as deeply flawed.

Put it this way: if interest rates doubled from 1.5 per cent to 3 per cent they would still be less than any long-term average rate — historically, it would be no big deal. But in terms of mortgage servicing costs, especially in an exceptionally low-growth wage environment, this will be a major problem.

Why it’s a problem can be seen from the following graphs. First, the graph below from Martin North’s Digital Finance Analytics blog. The chart maps debt service ratios for 16 advanced-economy nations. The dotted yellow line is Australia and depending on which month is noted we are the second or third highest. Near the head of the pack is not middle of the pack. And this while Australia has its lowest ever mortgage rates.

Second, if we look only at the Anglosphere and consider, instead of debt servicing, the total household debt to gross domestic output the result for Australia is even more evident. Australia is that black line, apparently headed ever upwards – only apparently of course, nothing goes up forever. 

It’s ok to be ahead of the pack this way but at some stage we need to re-join the rest. And preferably we need to do that without a major economic shock – a significant lift in productivity would be ideal.

Third, recent interest rates tell a significant story. They are almost certainly as low as they can go and the next rise will very likely be upwards. The graph below shows the situation: from 17.5% in 1990 to 1.5% today.

Then there are recent figures from the Bank of International Settlements – see table below: Australia ranks third on the measure of household debt to GDP, reinforcing Kirby’s point. (A recent update on the figures has Australia jumping Denmark to be second on the list.)

Much of this debt is borrowed abroad; according to Standard & Poor’s our net foreign debt is equivalent to about 60% of GDP and is the largest such ratio in the OECD. 

This means that not only are our mortgage debt servicing costs higher than directly comparable countries but that the debt is largely borrowed off-shore and consequently subject to any correction in Australia’s credit rating (and that can only go one way from AAA).

Kirby mentions low wage growth as a factor (in the quoted section above). And he is right to do so. A clear idea of what that low wage growth, and sluggish business conditions in the aftermath of the mining investment boom, entails can be had from the graph below (from MacroBusiness).

The chart tracks real disposable income per head of population from the beginning of the GFC 10 years ago to today. The USA is shown in blue and Australia in Orange. In the last decade Australia’s real disposable income per person has increased by only a miserly 3% while America – in so much trouble they elected Donald Trump – has seen triple that. (This is not to suggest that the US has a more equitable income distribution than Australia; we know they don’t.)

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The second of Kirby’s housing market lies concerns interest only mortgages – his claim is that the regulators have been playing down the significance of the high proportion of interest only loans being taken up. From the article: 

… interest-only loans are now very nearly 40 per cent of the market. Yes, they have slipped ever so slightly as a percentage of the overall market, but as a single factor it is very significant.

Let’s put it another way; 40 per cent of new mortgages going out the door at the major banks are taken by people who have no intention whatsoever of paying down the principal. They are banking 100 per cent on price appreciation to make money.

Worse still, interest-only loans are promoted to investors who are heavily focused on negative gearing. In other words, they are happy to make a loss on annual running of the property because they get tax deductions. But what if the prices don’t go up and the losses continue in the annual running costs of the property? Interest-only loans are the market’s fault line.

According to the Australian Securities and Investments Commission (ASIC) website 25% of owner-occupier loans in 2015 were interest-only. For investors that figure was around 65%. Given that in recent time investor activity in the market has been roughly equivalent to owner-occupier activity then Kirby is very close to the mark with his 40% figure.

His primary point here is that those who expect the same behaviour from markets over extended periods of time and through changing conditions are at some stage going to be disappointed. If price appreciation is an investor’s sole purpose for being in the market then it will sometimes end badly.

Prices cannot and do not constantly go up. There are and must be adjustments in the direction and magnitude of price changes from time to time. The graph below (from AMP) shows that indeed price falls do occur. The anomaly is not that price falls occur but that falls since the mid-1990s have been relatively rare.

It is worth noting that since the last data point on the graph prices have risen even higher; the December quarter’s increase alone was in excess of 4% across the nation. Sydney and Melbourne recorded increases over 5% (though these have apparently been in thinner markets).

Most importantly it is very unlikely that prices can rise as far above the trend line in the current period as they have in the past before falling back. 

The reason for this is simple: sensitivity to interest rate rises and the likelihood that rates will have to rise if house price inflation is not contained by imminent stricter macro-prudential requirements foreshadowed recently by both ASIC and the Australian Prudential Regulation Authority (APRA).

The real question is how hard will the landing be when prices do fall.