Interest rates will stay lower for longer

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Household debt is at record levels. Mortgage stress is at record levels. Yet interest rates are at a record low. What would happen if interest rates were to rise to historic levels and predictions of 50 per cent of Australian households suffering mortgage stress became a reality?

Is high debt actually putting a ceiling on RBA rates rises and do we need to completely rethink what “normal” interest rates now look like?

Australian household debt has reached a new record at an average debt to income ratio of 189 per cent.  The Reserve Bank governor Philip Lowe has cited concerns that this level of debt could force households to curb spending if house prices suddenly fell, bringing the economy to a grinding halt.

What he didn’t say was that the same concerns should exist if interest rates rise. In fact, as repayments don’t actually rise with falling home prices but they do with rising interest rates, there should be more concern about rising rates than falling home prices.

In Australia, debt is dominated by households.  When interest rates rise it will be household budgets that become the brake on the economy, not government.  So when we are trying to forecast interest rates, it is the household sector that is the most relevant.

On one hand we have higher debt than almost all of our global peers.  On the other hand, interest payments are lower than long term averages and household assets are also at record levels.

So what is the real situation with household debt and the ability to cope with rising repayments?  We analyse this below, starting with the latest raw data and then making some observations that are relevant for forecasting interest rates.

Leverage isn’t bad if it’s affordable. Australians spend 8.7 per cent of their household income on interest payments, which is slightly below the average of the past 20 years, at 9.1 per cent.

According to researcher Digital Finance Analytics, 24 per cent of all households with a mortgage are experiencing stress (defined as income not covering ongoing costs), compared with 15 per cent in 2011. DFA says 52,000 households are at risk of default in the next 12 months.

As total debt to income rises, so does sensitivity to changes in rates. Over the past 20 years, Australian household debt to income has risen by 80 per cent.  In that same time, mortgage rates have dropped by around 1.5 per cent a year, and housing debt as a percentage of total household debt has risen, making interest costs per dollar of debt much lower.

The result is, as shown above, only 8.7 per cent of household income is currently spent on interest payments, below the 20-year average of 9.1 per cent and well off the peak of 12.2 per cent in September 2008.  At current interest rates, this is manageable.  However, with so much more debt per $1 of income, households are much more sensitive to rate increases.

The impact that a 25 basis point rate rise would have on household disposable income, and therefore potential household spending, doubled between 1997 and 2011. In other words, a 25 bps increase in 2011 had the same effect as a 50 bps increase in 1997.

Sensitivity has risen by the same amount again between 2011 and 2017 as debt has continued to rise and income growth has slowed to record lows. A 25 bps increase in rates today would have the same effect on household incomes as a 75 bps increase in 1997.

This is a critical point when forecasting the future of interest rates in Australia. The RBA would only need to increase rates by one-third as much as it did to in the 1990s to have the same tightening effect.

The 1.5 per cent increase in 1999/2000 would only need to be 50 bps today.  Economists calling for rates to rise two per cent from today’s levels are implying the equivalent of a six per cent rise given today’s household debt levels. Clearly, that is not sensible policy and extremely unlikely.

Governor Lowe’s comments about the RBA being concerned that a housing market downturn would have a sharp impact on household spending, skirt around the real issue.  Starting with the record high level of debt to income ratios for households is the right focus, but mortgage payments don’t rise with falling housing prices, but they do rise with rising interest rates.  Record debt to income, record low income growth, near record underemployment all means that any interest rate increase will have a very sharp impact on household spending.

Mortgage stress has risen from 11 per cent in 2000 to 15 per cent in 2011 and then a sharp increase in the past few years to 23 per cent in early 2017.

Remembering that mortgage stress is defined as having less income than needed to cover the mortgage and household bills, that means that for a quarter of mortgaged households in Australia, an increase in interest rates will directly correlate to less spending.  This is a particular worry for the retail sector, already struggling with low consumer spending and increasing digital competition.

Default risk has also risen sharply in recently years and will rise even sharper under a rising interest rate environment, something that the RBA is acutely aware of.  DFA forecasts show more than 52,000 households at risk of default in the next 12 months, with 32,000 already in “severe stress”, meaning they were unable to meet repayments on their current income.  This is a direct result of Australia’s weak employment market and high underemployment.

When averages fall to a record low, the extreme end of the curve will be suffering disproportionately, most likely in mining, retail or manufacturing where hours worked have fallen the sharpest.

Current market pricing implies that the RBA will increase the cash rate to at least 3.5 per cent over the next 10 years.  This two percentage point increase would have the same impact as a six percentage point increase in the 1990s.

The last time we saw that level of tightening was 1980 in the war of inflation, a vastly different environment than today.  After the inflationary era of the 1970s and 1980s, the largest increase in any 10-year period was 3.5 per cent.

Based on household sensitivity being three times higher today, this suggests a more likely peak in interest rates at around one to 1.5 percentage points higher than today, taking them to 2.5 per cent or three per cent.  Depending upon the time it takes to reach this peak, this suggests a 10-year fair value of two per cent to 2.5 per cent, and that current rates are 35 bps to 60 bps overpriced.


Craig Swanger is senior economist at FIIG, a specialist fixed income investment house.


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