Where are property prices going?

Dear Subscriber,

Are you wondering where residential property prices are heading? I am.

In general, opinions are sharply divided between the many optimists and a few pessimists who receive enormous publicity.

One of them wrote a much-commented on article with lots of very persuasive graphs showing that the Australian property buyer cannot afford to pay any more because our debt levels are already too high.

What, however, if mortgage interest rates drop?

The article below is about how the most important ingredient in our property market - mortgage interest rates - has dropped substantially in the last 12 months, has potential to drop even more and why this could be important.

As ever, I look forward to hearing from you.

Yours truly,

Christoph Schnelle
Adv Dip.FS (FP) EPA Acc Level 2
SMSF Specialist Advisor

* * *

Where are property prices going?

Something very important happened in 2011: The Australian Government mortgage rate (better known as the 10-year bond yield) dropped by a third during the year from 5.6% to 3.8%.

Why is this important for property prices? Because residential mortgage interest rates are based on the Australian Government 10-year bond yield. If that yield drops (and doesn’t go back up), then sooner or later residential mortgage interest rates follow. Lower mortgage rates normally are a boon to property prices.

Why is the Australian Government 10 year bond yield so important for mortgage interest rates?

Historically, the 10 year Australian Government interest rate has always been very similar to the standard mortgage rate:

Source: RBA Statistical Tables as of 26/1/2012

The reason is that the Australian Government 10 year bond interest rate is the benchmark from which other interest rates in Australia are priced, including mortgages.

We in Australia still pay the highest mortgage interest rates among AAA rated countries (see below) but the above table makes me optimistic that our rates may well come down further because the 10 year bond rate has just dropped by 1.8% but our mortgage interest rates have only dropped by 0.5%.

More reasons for optimism

Australia has been an anomaly for quite a few years – an AAA rated country that was paying much higher interest rates than any other AAA rated country. As a result our mortgage rates have also been higher.

This anomaly now looks as if it is starting to disappear – people in the world seem to start realising that Australia is not just comparatively well governed and financially prudent but that it will likely stay that way.

Below is a table of all AAA rated countries in the world together with their estimated residential mortgage rates.

AAA is the highest bond rating, meaning the ratings agencies think that these countries are the safest government borrowers in the world.

Liechtenstein and Luxembourg are also rated AAA, but I have excluded them from the table as their markets are too small and added the USA as it is significant although only rated AA+.

I do not know whether property prices will go up or down in the future but I am more optimistic than I have been for years because one of the most important ingredients in property prices - mortgage interest rates - looks much more likely to fall by 1-1.5% than to stay the same or rise.

The next bit is for those who enjoy more technical details

The picture below shows the yield curves for Australian Government bonds at the end of 2010 and 2011. For example the red line shows that at the end of 2011 the 2 year bonds had an interest rate (yield) of just under 3.25% and 5 year bonds a yield of just over 3.25% while a year earlier (the blue line) 2 year bonds had a yield of about 5.1% and 5 year bonds had a yield of about 5.3%.

Source: RBA and fureyous.com.au

The blue line is a 'normal' yield curve showing that the government pays lower interest rates for 1 year bonds bonds than for 10 year bonds. The red yield curve is quite crazy, showing that bonds with less than 1 year to go pay more interest than any other duration.

It is as if the yield curve predicts a deep recession in 2 years (in recessions, interest rates are usually lower because fewer people want to borrow) and that everything will get better afterwards.

There is another possibility for the strange shape: The RBA controls the short (left) end of the yield curve and has set overnight money at 4.25% while it should really be less than 3.25%.

If the latter is true, it would explain why the Reserve Bank keeps cutting rates at the moment. It may also explain why the banks have passed on the last two rate cuts (they may not pass on future ones) - if they keep mortgage rates too high it will be too easy for other competitors to establish themselves again.

This message was sent by Christoph Schnelle of In Your Interest Financial Planning.
Click here to email Christoph or phone us on 1800 332 225.

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