Rates on a knife edge as discounting and time on market increase

Today I am going to drill into two key measures of real-time housing market activity: vendor discounting and average time on market. But before I do, I want to take stock of the all-important “rate debate”, which is so crucial to divining our housing destiny. 

Rismark’s bearish view on 2011 house prices (juxtaposed against a bullish position on rents), which we began outlining in September 2010, was predicated most importantly on our belief that rates would rise several times in the year ahead, which, we argued, would lead to “downward pressure on dwelling prices”. 

In November last year we got two hikes (care of the bank “top ups”), and, as I have explained too many times to count, we arguably received a brace of further “virtual hikes” in 2011 via the impact of RBA “jawboning” on the spectre of rate increases. In particular, all the survey data suggests households have been budgeting on two to three additional hikes, which has helped crush consumer confidence.

As I have noted here before, the financial markets are pricing in a steep reduction in the RBA’s official cash rate over the coming year. These are the same folks who at various times have given us prices that implied rate cuts in 2010 (they rose), rate cuts earlier this year (they stayed on hold), and, at one juncture, a 100% probability of two rate cuts in October (no change). Suffice it to say, the financial markets have been relentlessly wrong. But then, as the RBA and I have gone to some lengths to explain, the interest rate changes implied by financial market prices can be quite misleading. 

Notwithstanding a bounce back in global sentiment in recent days (bet you did not read about the positive US jobs report on Friday night that trounced analyst expectations?), a number of the RBA’s main media proxies have sung a decidedly dovish – i.e., rates heading lower – tune of late. This was presumably prompted by both private prodding and by the fact the RBA has, for the first time in a long time, explicitly countenanced “easing” policy should demand require it. One especially worded-up journo, who implied that he had access to the otherwise highly confidential discussions that take place at the RBA’s board level, claimed that the bank almost cut the cash rate in October but was prevented from doing so by the looming third-quarter inflation data. 

The RBA has invested an enormous amount of capital in its story around the positive income shock wrought by the structural increase in demand for Australian exports from developing Asian countries, which, it believes, will generate long-term inflationary pressures and the need for higher interest rates. It has given scores of speeches and parliamentary testimonies, and published vast volumes of research, in support of this specific thesis. It desperately needs some cover if it is to temporarily abandon it. One partial canopy has been supplied via the modest rise in the domestic unemployment rate to a still-low 5.3%. Yet as a purportedly “inflation-targeting” central bank, the RBA would ideally like the inflation data to also fall in line. 

For what it is worth, I employ the “inflation-targeting” label hesitantly since it is no longer clear whether the RBA has the political fortitude to respond to its forecasts of high inflation – either because it simply has no faith in its own guesses (one distinct possibility) and/or because it is worried about the fallout associated with hiking without the hard inflation case to back up its decision. At this stage, the RBA looks like it will only move rates into genuinely restrictive territory after the event: that is, when it has demonstrable evidence that the inflation cat is out of the bag. 

It seems to think that the risks of getting rate hikes wrong are too great to tolerate, which helps explain why the two core measures of inflation in Australia have averaged 3.2% per annum since 2002 (I only select June 2002 to put some distance between that date and the GST in July 2000). That is, the RBA likely has a policy bias to overshoot its target 2 % to 3% per annum band. 

Many once-hawkish economists have jumped on the burgeoning rate cut bandwagon, which was first kicked off by a now-famous reversal in the views of Westpac’s experienced chief economist, Bill Evans. Evans, who, to his credit, has held dovish dispositions for quite some time now, was reportedly pushed over the edge by a disturbing trip to Europe and North America. Following these meetings, Evans swung from projecting hikes to four cuts, commencing in December. 

After the high second-quarter inflation numbers – which were subsequently revised down – Evans looked like he had spent too much time in the European sun. But with the advent of the US debt ceiling crisis, ever-worsening European sovereign debt problems that threaten the fabric of the entire Euro zone, IMF downgrades to its global growth forecasts, and weakening local employment growth, Evans has quite rightly become the genius de jour. And all power to him: he deserves considerable kudos for making what was, at the time, a rather brave call. 

The only thing we know with certainty is that nobody, including the RBA, really has much of an idea what is actually going to happen on the first Tuesday of November. Some are paid to guess (economists), others are willing to punt (investors), and some like me get to bite their tongues until they obtain better information. 

And it is fair to say monetary policy rests on yet another knife edge, as it has done for much of 2011. If we get another upward movement in the unemployment rate combined with a, say, circa  2% (annualised) or less core inflation outcome, it seems that the RBA is set to abandon its February and August forecasts and undertake a major policy turn. Absent a meltdown overseas, and subject to the impact of bank funding costs on the latter’s “ability” to pass through one-for-one changes in the RBA’s cash rate, the first cut, if it comes, is likely to be 25 basis points. 

In a low third-quarter-inflation scenario, the RBA’s goal, one assumes, will be to put monetary policy back on a more balanced, or “neutral” footing, until it gets more dependable data on the local and global outlook. This implies a modest easing of policy in the form of one to two cash rate cuts. 

As most of the circa 5 million households with mortgages are on fully variable rate loans that can adjust with changes to the RBA’s cash rate, the influence of this decision on Australia’s listless housing market should be immediate. While we have yet to see any discernible improvement in housing atmospherics outside of Sydney, there are some partial data, such as the housing finance flows, which insinuate that it may be starting to “base”. 

The most important change is already taking place. This relates to the expectations of households regarding the future course of rates. Just as all the talk of rate hikes earlier in the year acted as de facto increases, tamping consumer and housing demand, so the unravelling of this sentiment will almost certainly have the opposite effect. 

The more thorny monetary policy question is what happens if core inflation prints in the third quarter at the top, or, heaven forbid, above the RBA’s 2% 3% target range? In quarterly terms, if the RBA’s two preferred measures of underlying inflation come out at around 0.7% or higher, the central bank will be placed in yet another bind. 

It will no longer have the inflation cover it was seeking: that is, evidence that price pressures are benign, and could be projected to remain around “two point something”. A bad third-quarter release will be all the more surprising given the ABS is adopting a new weighting system that many argue will help eliminate an upward bias, and a more comprehensive seasonal-adjustment method that reduces the risk of seasonally high (or low!) price changes giving us a bum-steer.

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 Similar levels of complexity characterise current housing dynamics. Today I want to touch on two variables that RP Data and Rismark track closely: “vendor discounting”, which measures the amount by which owners have to reduce their list prices in order to secure a sale; and “time on market”, which, as the name implies, simply tells us how long homes remain available for sale before they are sold.
The first chart below quantifies the vendor discount over time for Sydney, Melbourne and Brisbane houses. And the story is an interesting one. Whereas owners of dwellings in Brisbane are having, on average, to drop their list prices by nearly 9% before triggering a sale, the average Sydneysiders’ discount is a considerably lower 6.5%. In comparison to Brisbane, the Melbourne market also looks healthy, with the three-month moving average discount currently sitting at 7.2%. Click to enlarge

 

As the chart above highlights, discounting is pro-cyclical, and the germane benchmark is obviously the 2008 crisis. Recall that during this episode the RBA had its cash rate slashed by a stunning 300 basis points by December 2008, whereas rates have been held at above-average levels throughout 2011. 

Drilling into the detail further, the Brisbane and Melbourne discounts look like mirror images of their 2008 forebears. In fact, conditions in Brisbane appear a tad worse, which may be explained by the impact of the floods. While it is similarly difficult to distinguish between the discounting in Melbourne in circa 2008 and 2011, today’s correction should be contextualised against the 29% capital growth realised by Melbourne homes over 2009-10. 

It is Australia’s largest city, Sydney, that seems the stand-out. At the depths of the GFC, Sydneysiders were compelled to cut the value of their homes by 8% to crystallise buy-side interest. Today the discount is 15% to 20% less, and has not increased – or decreased, depending on which way you look at it – nearly as much as its Melbourne or Brisbane equivalents. 

This accords with the story told by RP Data-Rismark’s hedonic indices: while Sydney homes have actually increased in value over the last 12 months, Melbourne and Brisbane dwelling values are down by 4.3% and 6.1%, respectively.  In the year to date, the Melbourne downdraft has been more noticeable, with values off 6% from their highs. 

The vendor discounting narrative is reinforced by our time on market data (see next chart below). Once again, we find historically very poor conditions prevailing in the Brisbane market, which look as bad as those that emerged during the GFC. Today the typical home takes about 58 days to sell. The Melbourne market also looks to be enduring a repeat of the 2008 experience, with the average time between listing and sale estimated to be around 50 days. It is Sydney homes that have again bucked the trend, with the time on market of 49 days well down on the 60 days recorded at the 2008 peak. Click to enlarge

 

These housing dynamics are important to the RBA. At the limit, it will be cognisant of the risks to bank balance sheets; more specifically, a deterioration in collateral values increasing the probability of a transmission of the North Atlantic contagion. If the stability of the overall financial system is in any way threatened, the RBA will not hesitate to act by reducing rates and ramping up the liquidity it provides deposit-taking institutions via its “repo” facilities. Think 2008 redux. 

This time around, however, Australian banks have far more secure funding lines in place (i.e., with more finance sourced from domestic depositors as opposed to fickle wholesale creditors), and know that the Commonwealth is prepared to use its unblemished AAA credit-rating, if required, to act as a guarantor (or lender) of last resort.

Christopher Joye is a leading financial economist and works with Rismark International. Rismark and RP Data provide house price analytics products, and solutions that enable investors to go long and/or short the housing market. The above article is not investment advice.