The Reserve Bank of Australia (RBA) is caught between managing systemic risks in a hot housing sector and propping up a weak labour market.
In a research note called “The RBA’s Rock and a Hard Place,” Morgan Stanley analysts argue that those competing forces have boxed the RBA in on its interest rate policy.
They think that the RBA will keep benchmark interest rates on hold at 1.5% until 2019 and make further use of macro-prudential measures to balance the economy. Previously, the bank forecast a rate cut in Q3 2017 followed by two increases in 2018.
Currently, the market for interest rate futures is pricing the RBA to hike rates by August 2018. Morgan Stanley said that the current market pricing doesn’t take into account that a benchmark rate of 3% is equivalent to about 6.25% before the global financial crisis (GFC), given that Australia’s household leverage has continued to spiral.
That high leverage, in connection with speculative conditions in the Sydney and Melbourne housing markets, is the “rock” that Morgan Stanley refers to which is preventing the RBA from cutting rates further.
The bank cites the prevalence of housing investment strategies based on interest-only loans at or around an 80% loan-to-value ratio and with negative gearing (i.e. making a rental loss). Analysts see this strategy “as speculative in that its payoff is entirely dependent on capital gains”.
This chart shows the the increase in investor-held properties in Australia that are negatively geared.
Given such conditions, the “rock” is plainly obvious and RBA governor Philip Lowe said as much in his speech on April 5, stating that a reduction in rates would encourage people to borrow more, which would have the probable effect of pushing up house prices further.
That brings us to the “hard place”: a weak and deteriorating labour market.
The unemployment rate rose back up to 5.9% in February, and within that figure MS noted that underemployment (people who are working but would like to work more hours) hit a 40-year high of 8.7%.
Importantly, Morgan Stanley highlights the threat to the unemployment rate from a pullback in the construction sector.
The bank’s analysts predict that declining residential construction activity (mainly for apartments) will increase the unemployment rate to around 6.4% in the first half of 2018.
“The broader construction sector now employs over 9% of the labour force, above the peak of the resources capex boom. We believe the correction underway will displace ~150-200k largely full-time jobs (1.6% of the labour force)”, they said.
Analysts said that a sharp deterioration in the labour market would in fact prompt the RBA to cut rates further “given the recession risk that would pose.” However, the bank assessed that current dynamics pointed to “a flat, or slowly increasing unemployment rate”.
In view of that, the bank is in favour of more macro-prudential (MacroPru) measures seeing as the RBA is hamstrung on interest rates.
The bank sees MacroPru measures as particularly effective in the Australian economy.
“We think Australia’s concentrated banking system and mortgage market are very well suited for MacroPru, with the regulators having sweeping powers relative to more fragmented or constrained systems abroad,” the bank said.
Following on from the latest MacroPru regulations on March 31, the bank’s analysts make the case that a further round of measures will be forthcoming around mid-year. The new measures will include increased risk weightings on investor loans, with the growth of investor loans seen as a key driver of speculation in the sector.
Morgan Stanley analysts predict that major lenders will be required to increase their capital base by $12.5-$16 billion across the sector. That’s about consistent with the position of UBS in their appraisal last week of the likely effect that further measures would have on the major banks’ capital positions.
The competing forces of high household leverage tied to a hot property market, and weak employment growth combined with the further use of MacroPru later this year all inform Morgan Stanley’s prediction for rates to now remain on hold until 2019.