Today the Reserve Bank of Australia (RBA) will host its March board meeting, with the outcome seemingly hanging in the balance.
At the close on Friday, futures markets priced a cut as more likely than not at a 62% likelihood, with another cut to a cash rate of 2% by May considered all but certain.
Implied yields on November 2015 cash rate futures contracts are now plumbing new depths at just 1.69%, reflective of two further cuts being fully priced in for this calendar year.
Viewpoints are split on this month’s decision. Via the medium of Twitter, I enquired of Shane Oliver of AMP if he was sticking with a cut forecast for March, and given that his response was only three letters long he seemed fairly unequivocal.
Bill Evans of Westpac has also taken the view that if further rate cuts are indeed deemed necessary then they should be cut now rather than later, perhaps seeing this as the so-termed “path of least regret”.
Evans would prefer to see an immediate cut with an explicit easing bias, regardless of whether that bias was later acted upon.
On the other hand, Terry McCrann took to the format of video on Friday in order to predict rates staying on hold, which at least should keep debate centred upon monetary policy this month rather than his use of punctuation.
Risks to each decision
A number of factors which I have previously looked at in turn in greater detail here suggest that the labour market, investment outlook and inflation may each be soft enough to warrant another cut, but the RBA has itself identified a risk that lower rates could ignite a rocket under Sydney’s buoyant housing market.
However, given that markets are presently torn between rates staying on hold or being cut, a decision to stay on hold presumably also risks sending the dollar back up and away from the assumed ~75 cents that the Board would likely prefer to see.
Interest rate history
While interest rate movements and expectations are far from being the sole driver of our property markets, the impacts of adjustments to monetary policy are likely to be felt more keenly than they were prior to the deregulation of financial markets.
Over the past quarter of a century we have seen the commencement of five easing cycles, and in every case dwelling prices have subsequently responded by rising within the following 24 months, although, as one would expect in illiquid markets, there can be a lag.
What we can conclude from the above is that interest rate cuts are rarely “lone wolves” and that they tend to come in a salvo.
The RBA’s rhetoric over the past year has certainly indicated a clear preference towards interest rate stability, but after a long period of inaction the February decision to ease by 25bps to 2.25% betrayed a view that more than one cut is deemed likely to be required.
Discount rates and fair values
Just as the Gordon growth model fulfils a simple method of share price valuation, it is of course possible to model a fundamental or fair value for housing markets.
Such a model can be used in order to weigh up a rent versus buy decision through discounting expected future cash flows and using real mortgage rates as the discount rate.
However, if you have ever undertaken such an exercise you will have quickly discovered just how sensitive the outcome is to assumptions relating to real rental growth and expected capital appreciation.
It has always been my contention that while sustained real rental growth is likely in certain land-locked capital city areas due to growing demand and inelastic supply (e.g. inner ring Sydney), it is unrealistic to expect this to occur in most regional or more elastic outer suburban markets over the longer term.
Assuming real rental growth in a fair value model increases the present value of future cash flows from rental payments (or the implied user cost) net of running costs such as repairs, rates and insurance.
These same forces are also what give rise to expected future capital appreciation – although to some extent this is offset by the discounting applied to the final capital gains upon sale.
These two key inputs are inter-related, and generally suggest that home ownership is marginally more attractive than renting where real rental growth is expected, though only for longer term owners due to the high transaction cost associated with Australia housing.
While the future of course in unpredictable, a widespread belief that mortgage rates will be lower in the future than they were in the past are a key input into the fundamental value of housing – and by taking on greater household debt, the market has pushed in turn paradoxically pushed the “neutral” rate of interest lower.
Real estate cycles
Capital city markets with an expanding population will always cycle as construction and therefore dwelling supply ebbs and flows in response to demand.
But, as I looked at in more detail here, when it comes to property market psychology expectations of dwelling price movements – and the emotions of fear and greed which these suppositions engender – play at least as important a role in the near term and therefore accentuate the cycles.
This is precisely why another interest rate cut in this easing cycle will likely send Sydney’s property market soaring for the stars – with 2015 forecasts already ranging from 7 to 12% capital growth and risks to the upside – simply because recent history leads to a critical mass of those active at the margin to an ingrained belief that prices will rise.
CoreLogic’s preliminary weekend auction clearance rates from Melbourne (and possibly even to a certain extent Canberra) and a huge surge in the latest housing finance data suggest that it is not only folk in Sydney who presently feel this way.
I should add that from the hordes of people I witnessed at viewings on Saturday, the inner ring Brisbane market now appears very likely to heat up too.
For all of the above, real dwelling price growth through this cycle outside the largest cities has been weak, suggesting that the easy gains in Australia’s housing markets took place further towards the left of the interest rate history chart above.
One of the issues facing property market commentary has been recency bias which has led to some unrealistic expectations of real growth in perpetuity in more elastic markets where this was never probable, or even likely.
Greater Sydney has suffered from a chronic supply deficiencies which should have been obvious to observers close to a decade ago, and despite an increase in approvals, the lack of appropriate supply is now coming home to roost.
There is an avalanche of data due out this week, so stay tuned for that!
PETE WARGENT is the co-founder of AllenWargent property buyers (London, Sydney) and a best-selling author and blogger. His new book ‘Four Green Houses and a Red Hotel‘ is out now. This story originally appeared on Property Observer.