We have had 68 of the 75 basis points of cuts passed through to borrowers thus far, which implies home values need to jump by 20 per cent if these changes are perceived to be permanent.
If the RBA really wants to hit its legislated “full employment” target and boost wage growth back to historical trend, it will need to shunt rates a lot lower notwithstanding its own stated “lower-bound” of a 0.25 per cent cash rate.
As I’ve explained before, getting the jobless rate down to between 4 per cent and 4.5 per cent (from 5.1 per cent) will require a large amount of additional monetary stimulus – much more than the RBA will get from the partial pass through on the next two cuts. And this could easily push house prices 30 per cent beyond their June 2019 trough.
Across Australia’s eight capital cities, dwelling values are 8 per cent above their mid-2019 nadir. Sydney and Melbourne prices are leading the way with even stronger capital gains north of 11 per cent on a non-annualised basis.
This is a little stronger than the run rate we outlined in April 2019 to get to 10 per cent appreciation over the following 12 months, but that analysis banked on two cuts and we have been furnished with three.
The RBA’s intellectual hypocrisy
Unfortunately for the RBA, this price action betrays its intellectual hypocrisy. During the 2012 to 2017 boom, the RBA repeatedly claimed that the 50 per cent increase in national prices had little to do with its slashing the cash rate from 4.75 per cent to 1.50 per cent.
No, other factors like population growth and inert housing supply were to blame even though its own internal research found that mortgage rates accounted for almost all the price inflation over this period.
Fast forward to 2020 and now the RBA tells us that the sudden boom in prices proves that its “monetary policy transmission mechanism is working”! Those Martin Place mandarins are the consummate politicians, which is why Treasurer Josh Frydenberg should be fretting about their attempts to control fiscal policy.
This is another classic case of hypocrisy: the RBA demands absolute political independence when it comes to monetary policy, but feels no hesitation in seeking to (politically) influence fiscal policy.
When national house prices did indeed roll over in 2017 along our expected 10 per cent drawdown trajectory, I completely exited about $400 million of residential mortgage-backed securities (RMBS) on the basis that their credit spreads would be forced wider given rapidly rising leverage and mortgage arrears.
At the time, Standard & Poor’s RMBS arrears index signalled arrears were tracking sideways in a benign fashion. This was inconsistent with anecdotal evidence that defaults were going up as a result of higher mortgage rates flowing from the regulator’s macro-prudential constraints on lending, coupled with tougher refinancing conditions as banks tightened credit criteria (including reducing maximum loan-to-value ratios).
Our hypothesis was that record volumes of new RMBS issuance were flooding S&P’s index with clean (ie, default-free) home loan portfolios that were artificially suppressing the index’s arrears rate when the true system-wide default rate was actually trending higher.
(S&P erroneously distinguishes between “arrears” and “defaults”, assuming that a missed repayment is not a default when under a loan contract you are in technical default the moment you miss a payment.)
So I asked my team to build the world’s first compositionally-adjusted RMBS arrears index that uses a multi-factor regression method to control for a range of portfolio biases that can spuriously influence reported arrears rates. These variables include the time since the RMBS bond was issued, the loan-to-value ratio of the mortgages, the weighted-average life of the loans, and their geographic location.
Our hedonic RMBS arrears index showed that default rates in Australia had, as we suspected, been appreciating consistently between 2014 and 2018. Combined with the biggest drop in house prices on record, this did eventually force credit RMBS spreads wider in 2018 and early 2019.
On the back of our 2019 view that the bust would be quickly replaced with another boom (which alongside lower mortgage rates would normalise arrears), we leapt back into the RMBS market, buying $756 million of AAA rated product.
And we can now see via our hedonic RMBS arrears index that mortgage default rates have flatlined after four years of consistently increasing, with the latest data hinting at the possibility they might actually start falling.
Macquarie’s new hybrid
Our conviction in the robust housing recovery was also a key driver of our long-held forecast that S&P would be compelled to upgrade Australia’s economic risk score, which would in turn upgrade the credit ratings on the major banks’ Tier 2 bonds and AT1 hybrids to BBB+ and BBB- respectively, pushing the latter into the all-important “investment-grade” band. S&P finally obliged in November last year.
On this note, Macquarie Bank launched a small new hybrid (ASX: MBLPB) during the week to replace its MBLPA security with an expected credit spread of 290 basis points above the quarterly bank bill swap rate, which looks about 10 basis points cheap to Macquarie’s interpolated curve. (The new hybrid has an expected repayment date of 5.75 years.)
Unlike the major banks’ investment-grade (or BBB-) hybrids, this security technically falls into the high-yield, or junk, bucket with an assumed BB+ rating. In the US, BB rated high-yield corporate bonds offer credit spreads of about 190 basis points above their equivalent cash benchmark, which is some 100 basis points inside (or inferior to) the Macquarie Bank security.
I’ve pointed out before that credit spreads on AA, A, BBB and BB rated US corporate bonds are now inside their 2007 levels, which makes these assets look extremely expensive. In contrast, financial credit spreads are trading at levels multiple those that prevailed in 2007 and appear comparatively cheap.
This is especially true if you consider that whereas leverage in the banking system has generally shrunk dramatically since 2007, US corporate leverage is back above its pre-crisis marks.
This is not to say all corporate credit is bad, and I have the freedom to invest in corporates and financials in my portfolios. It is more an observation about relative value opportunities.