The big risks that come with a housing asset bubble

The last 10 days have certainly been exciting enough, although as capital preservation-focused investment managers we prefer boring, reliable, predictable etc.

The market may well have been upset with the RBA after it left rates on hold and issued the most hawkish statement we have seen from Governor Bullock to date, but it did not change its rate outlook with rate cuts still priced into this calendar year. Caution has to be taken with placing a high reliance on the market’s predictive efficiency in Australia because here the financial system is dominated by the 4 major banks and of course we have a complicit media happy to fill column inches with the banks’ biased spin (all banks are short-term borrowers to be long-term lenders, that is banking). We expect that the RBA will remain on hold due to the political difficulties of increasing rates ahead of a federal election that is increasingly likely by the end of 2024. The warning, however, from the RBA is that the next federal government, together with the states, must take steps to reduce spending and debt.

Even with the RBA remaining hawkish we doubt that the RBA will increase rates again unless it sees inflation (RBA trimmed mean) on a quarterly basis increasing above 4% pa. There is a real chance that the RBA will not increase rates even if inflation continues to climb, at least initially, because it does not want to risk pricking the housing price bubble in Australia. There is a lot of misinformation spread by the usual invested groups about the Australian housing market. Claims that there is a housing shortage don’t stack up well against the surplus of apartments but even if this point is refuted there is no doubt that Australia has the highest household debt to income ratio in the developed world and the highest level of mortgage debt per capita in the world. An asset bubble that involves unproductive assets funded by debt is the most dangerous type of asset bubble. Unlike when an equity price bubble bursts there are no earnings to repay the debt over time. It would also have systemic implications for the banking systems. The hands-on approach and full implementation of Basel IV by APRA (including the recent retention of the 3% mortgage service buffer) is clear evidence that APRA recognises the risk of the housing asset bubble. Hopefully, APRA’s actions and prudent approach are enough to protect our banking system, however, there are several risks that need to be considered:

Australia has not suffered a recession since 1992, so we have not tested the Basel IV capital provisions.
While the APRA-regulated banking sector is well capitalised the non-bank sector operates without APRA oversight and is funded by opaque fund/trust structures where forced selling of illiquid real estate assets could well flow into the banking system. It is worth
re-watching “The Big Short” and investing some time in understanding how, in the US, it was the rise in defaults of the CCC-rated mortgage-backed securities that very quickly brought about forced selling of even the AAA-rated mortgage-backed securities. In Australia we have this same problem on steroids.
The extreme debt situation at a state level has left future governments with very few options to increase tax revenue to at least service this debt. Increasingly we will see all state governments increase taxes related to real estate. Why? Well, when famous criminal Willie Sutton was asked why he robbed banks he replied, “Because that’s where the money is!”

The real and awkward truth is that people that grow up living in the Western developed world do so in a bubble. There is no real understanding of the reality and daily stress to eat and stay warm enough to survive, that people endure outside of the Western developed world. The very idea that Australians put all their savings into real estate that services only the utility of providing shelter, rather than investing in future production and technology, is fundamental to the future economic prosperity of every Australian. The Australian media is shamefully focused on the inflation outlook only in relation to its impact on RBA interest rate policy. This ignores the fact that:

Inflation, not interest rates, severely impacts the less affluent that have fixed incomes or conduct low skilled labour hours.
Australia is a huge net borrower from overseas and as such our real cost of capital (at every level) is determined by our credit rating and the cost of funding from offshore.
The RBA can only influence the short end of the yield curve. The actual cost of capital in Australia is determined by the shape of the yield curve and most particularly by the 3 to 5-year part of the curve where most corporate borrowers’ debts are termed.

Interest Rates

Bond yields go “cerchio completo”. Treasury yields initially dramatically dropped with the fear of a US recession. Mid-week yields rose as fears that the US economy is quickly entering a recession were seen as overdone, while safe haven demand for bonds also ebbed as stock markets recovered. Late in the week Treasury yields fell again as economic outlook concerns re-emerged. Over the week yields actually rose undoing much of last week’s sudden drops, the 2-year Treasury rate up 0.18% to 4.05%, 10 years up 0.15% to 3.94%. At one stage during the week the inverse US yield curve had fully unwound.

Australian rates were less volatile than offshore however still had to grapple with the large global rate moves as well as contend with the RBA decision and commentary. The Board left the cash rate unchanged and retained a hawkish tone in the post‑meeting statement, especially that from the Governor. Overall Aust. rates were broadly unchanged for the week but still well below the levels in late July, prior to the start of the recent bout of volatility.

Major Credit Markets

Investment grade (IG) bond spreads widened as surprisingly weak US employment data stoked fears of a recession ahead, prompting investors to dump riskier assets and turn to safe-haven bonds. By weekend the rebound in equities markets had brought confidence back to credit markets with the US iTraxx index posting a rally over the week of 4 points to close at 0.577%, still off the recent late July lows of 0.51%. In context this level is still low.

Australian investment grade credit margins widened over the week, the Aust. iTraxx wider by 3 points to 0.72%. Buyers were absent for most of the week with major bank senior bonds wider by 3-4 points across the maturity curve and sub notes, which despite some late in the week buying demand, finished 3-8 points wider across the curve. This subsector is fragile to volatility and is where weak-kneed fund managers look to raise cash when volatility strikes.

High Yield Markets

There was some recovery in high yield markets once the rate and equity market volatility subsided, however mid-week HY spreads were some 60 points wider from levels two weeks earlier. This is a large move given the 2.66% starting level and highlights how tight the HY sector is after a huge run in 2024. A volatility spike causes a HY huge sell off especially when the initiating reason is economically based.

Hybrid margins eventually showed weakness to the equity market volatility. The average major bank hybrid margin widened by nearly 0.20% to finish the week at 2.185%. In index terms this was a fall of about 0.37%. Daily volumes did rise above average levels and were concentrated on longer-dated issues. This activity may have been influenced by Macquarie’s statement late last week that a new issue may be forthcoming. Typically, this does result in the sale of longer-dated hybrids. Volumes were also higher in MQGPC which traded well below swap rates as buyers sought to get access to a new Macquarie hybrid via reinvestment.

Listed Hybrid Market

Hybrids – margin moves over the week with market volatility

As mentioned above, hybrid margins eventually moved wider with the equity market volatility. The chart below shows the impact on the major bank curve. To remind, the blue dots show the latest data point and are labelled. The vertically corresponding red dots are the same security, the label left out for easier reading. Most effect was in the middle third of the curve, in particular NABPF, CBAPJ NABPH and AN3PJ. There was some uniform effect at the long end of the curve, however notably not NABPK.

For the non-majors, most hybrids showed weakness. AMPPB moved 1% wider, CGFPC by 0.50%. All IAG and Suncorp issues were also weak. From this chart it looks like non-major hybrids were more sold than the majors as shown above. The less creditworthiness and poorer liquidity appear to push investors to move out quickly once volatility arises.