We are now well into 2018 and it is timely to look at how the finance sector is shaping for the rest of the year.

Will Interest Rates Increase?

The answer is probably yes but not for the reason that most people think they will.  Most pundits believe the RBA will keep cash rate on hold for the foreseeable future.

According to the RBA the banks’ cost of funding generally decreased throughout 2017.  This has had two results: their net interest margin for existing borrowers has substantially improved, and they have been able to offer substantial discounts to attract new borrowers. 

But there is more recent evidence that funding costs are increasing again.  The three-month bank bill swap rate, a key component of home loan funding, has risen by about 22 bps (0.22%) over the past 5 months. This has mainly been due to factors outside Australia:  the winding back of government stimulus in developed economies as they emerge from recession and the strong inflationary stimulus in the US.  But intervention by our government regulator APRA is also having an ongoing effect. 

So far, both Suncorp and ME Bank have responded to these pressures by increasing interest rates on a range of home and investment loans.  I expect other lenders to follow suit over the next 2 months.

The CBA has been singled out for special attention by APRA, and is being compelled to set aside an extra $1 billion against liabilities until it brings its house into order.  This will have an impact on their cost of funding and when the largest lender decides to move, I expect the market to follow.

How Easy Is It To Obtain Finance?

Despite tightening credit controls the situation for home owners has changed very little over the past 3 years.  But following APRA pressure there is now an increased level scrutiny of borrowers’ living expenses:  going forward there will be much more emphasis on borrowers’ actual living costs rather than deemed minimum benchmarks that were adopted before.  This will put a much greater onus on prospective borrowers to run a tight financial ship before they seek to borrow money.

For multiple property investors the ability to borrow money has become much harder – most people do not realise that banks are now assessing all existing debts at 7.25% to 8% pa.  For an investor with $1M in outstanding loans that equates to a $30K to $40k difference in assessed annual cash flow capacity.

These borrowers can turn to non-bank sector for now but that comes with increased risk as it exposes those borrowers 100% to cost of funding in international wholesale markets with no safe haven backup if those markets tighten significantly as they did in 2007.

Property Prices

This squeeze on investors explains why property prices in major markets have plateaued and in some markets are falling. Michael Matusik argues that property prices are primarily influenced by the following:

• No. of people in full-time work
• Consumer confidence
• Availability of finance
• Population growth

These are all demand side factors which affect long term property prices.  Short term spikes can occur where the construction cycle gets out of sync through underdevelopment, over development or simply building too many of the wrong properties. 

But we are now seeing the effect of the winding back the availability of finance to investors.  There has been a collapse in demand from investors and this has not been taken up by a corresponding increase in the number of owner occupiers: first home buyers and upgraders, who in any case purchase different housing stock in different markets.

SQM Property Research forecasts that Sydney and Melbourne property prices will fall by up to 4 and 3 per cent respectively in 2018.  SQM Research maintains its view that based on its aggregate incomes to dwelling prices measure, Sydney property prices are 45% overvalued. 

What we are seeing is the boom in property prices diffusing as home owners seek cheaper housing in outer urban and regional property markets.  

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References

Commins, P. Interest rate hikes are on the way, but when and how fast? Australian Financial Review. 
Jacobs, S. One measure of Australian financial stress is rising at its fastest level since the GFC. Business Insider. 
Jacobs, S. Why rising rates in the $US200 trillion inter-bank funding market isn't cause for alarm - yet. Business Insider. 
Tan, S. Sydney and Melbourne house prices could fall as much as 4 per cent, says SQM. Australian Financial Review. 
Hughes, D. Property buyers brace for new round of interest rate hikes as funding costs rise. Australian Financial Review. 
McKinnon, T. Developments in Banks' Funding Costs and Lending Rates. Reserve Bank of Australia. 
Papuc, A and Spratt, S. Expensive money: Why the RBA may not raise rates any time soon. Sydney Morning Herald. 
Scutt, D. Financial stress is increasing in Australia as cost of living pressures mount. Business Insider.