Get Ready for a Rate Rise You Don’t Want

Rate cut drives auction boom

Australian Financial Review

Oh dear. People just don’t seem to get what’s happening here. RBA rate cuts aren’t a sign to load up on debt. This isn’t a fire sale on lending, where you get bargain basement prices.

This is the one purchase you’ll make that’s going to cost you more later on that you might think. In fact, it might cost you everything if you’re blind to the reality of a low cash rate.

I wonder if you’re one of those people that bought into the ‘boom’ over the weekend? If you did and paid over $500,000 for your purchase, please write in to me and explain your rationale.

I’d be fascinated to know why you just loaded up on an overpriced asset. Hopefully though, as a reader of Money Morning, you can see the far bigger picture at play here. I hope I get no emails on this.

The AFR article I quote above explains,

‘…national auctions preliminarily cleared at the highest rate for the year at 74.9 per cent, Corelogic said.’

It then goes on to quote auctioneer Damien Cooley,

Given interest rates are so low, investors are stepping in and buying real estate even though they are not getting the incredible return on yield, they are happy with the growth play.’

The old ‘growth play’ argument. If you’ve never heard of this, it’s really quite a simple premise. The idea is that you can take on ridiculous debt, with the view that over time the increase in the value of the property offsets the level of debt.

It’s banking on the fact that property prices will always go higher. The problem is this is a falsehood. Property does not only ever go up in value. It’s a complete myth.

For a start, property, just like stocks or gold or even cash, is an asset class. And all asset classes fluctuate in value. Property is just like stocks in that the price can go up and it can go down. The problem is most people take a very different mindset to property, compared to stocks. The reality is you only ever know the value of your property at two times — the day you buy it and the day you sell it.

And if you’re stuck trying to sell in a crashing market, well, you won’t be so smug then.

This ‘always goes up’ mindset is going to get a lot of people in a lot of trouble when they realise that cheap money and low rates don’t last forever.

This false ‘boom’ and the idea of ‘cheap money’ is all building to an incredible crescendo that’s going to see 30%, 40%, maybe even 50% knocked off the value of Australia’s property prices.

You think you’re a good borrower, but you’re incredibly risky

I’m expecting the Reserve Bank of Australia to make another rate cut this year. With rates at a record 1.5%, on Melbourne Cup day I expect they’ll cut again to 1.25%. They may even take an extraordinary leap into the unknown and cut a full half per cent to just 1%!

Now there’s no such thing as ‘sure thing’. And on Melbourne Cup Day of all days there’s absolutely no such thing as a sure thing. But in my book the RBA cutting rates again is probably as close as you’ll get to it.

Of course, if you’re a borrower you might think that’s amazing. How cheap will mortgages get then!

On the face of it you might think a low cash rate is good news. But it’s not. In fact, it will be disastrous. You see, the banks probably won’t pass on any more rate cuts to retail customers.

I wrote a bit about it in Money Morning on Saturday, but let me go a bit deeper.

You see, while the banks now have to deal with ‘margin squeeze’, they also have to adhere to responsible lending standards. Now sometimes these standards might be seen as ‘relaxed’. But it’s fair to say the standards held by the Aussie banks are historically better than those by our overseas counterparts, like the US or UK.

What that means is they try to avoid ‘risky’ lending. They don’t want to accumulate a bunch of bad debts on their books. They really don’t want lots of bad residential mortgage debt. The problem is they can’t just shut up shop, either.

If all of a sudden the Big Four ceased residential lending, it would be enough to spark a property crisis on its own. So they have to lend to the average punter overpaying for Aussie residential property. But the people they’re now lending to are ‘risky’.

And riskier loans cost the banks more. The banks won’t just absorb these higher costs. They’ll pass on the costs to the customer. This all means that further rate cuts could see retail interest rates rise.

Everyone I speak to has trouble believing that the banks could raise rates if the RBA cuts rates.

Don’t forget, banks are under no obligation to pass on more rate cuts by the RBA. The banks are public companies. They have to make a profit and return equity to shareholders, not appease the RBA.

And if they do raise rates while the RBA cuts again, it’s going to spell disaster for the Aussie property market.

Two options for the RBA, and both are bad

The Aussie economy just isn’t growing like it used to. Inflation doesn’t seem to be moving the way the RBA wants. And now every time the inflation figures aren’t how they ‘should’ be, the RBA cuts rates.

There are only so many cuts left, though. And each one has a diminishing effect on the economy. So it leaves the RBA with two choices.

  1. Implement a massive cut and hope for the best.
  2. Sit it out and see what happens

Either way is bad. Option one might spark things to life. But it could also send the markets into a spin. You can bet there’s no way the banks can deal with a 0.5% cut from here, either. The risk levels on their lending books will explode.

Option two is just as bad. It means the RBA has no impact on the economy whatsoever. So it just has to let things go — a ship with no rudder and no sails heading down a waterfall isn’t a great ship to be on…

I think the RBA is setting itself up for more rate cuts. And with that will come higher bank retail rates. With record numbers of people buying property at ‘cheap rates’, I wonder how many will be able to deal with an increase in their mortgage payments.

All of this in an economy with little direction. Of course, inflation could start to rise as the RBA hopes. It could rise and even rise out of control. Then rates would have to rise to keep it under control. And I bet the banks will be happy to bump up their retail rates then, too.

What this is all leading to is higher rates from the banks. Whether the RBA cuts or not, it matters little to a bank trying to make a profit in a highly risky market.

With higher bank rates come higher levels of mortgage stress. People who don’t plan for (or can’t afford) increases in rates start to default and fall into arrears on their mortgages.

This leads to extra supply in the market. Far more supply than demand. And that leads to falling prices — crashing prices. Continued retail rate increases will be calamitous for the Aussie property market. And for anyone loading up on cheap debt now — right on the limit of affordability — there’s a whole world of pain coming around the corner.

It will prove that property is as risky an asset class as any other, and in fact it does not always go up in value.


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