The impact of rising interest rates on consumer spending is starting to be felt by the market, as this quarter’s earnings reports are showing signs of reduced household spare cash flows, which is impacting economic activity.

The total value of the Australian residential property market ballooned out to almost $10.2 trillion at its peak in March 2022, up a staggering 42.26% from its pre-pandemic December 2019 peak of $7.17 trillion. During this same time period, the percentage of borrowers taking out home loans at a debt-to-income ratio in excess of 6 grew from roughly 15% to 25%. As at August 2022, around 40% of borrowers had a mortgage buffer of less than three months.

In a proposed 350 basis points (bps) increase scenario analysis (Reserve Bank of Australia October 2022), of which 325bps has already been realised as of February 2023, 15% of variable rate borrowers’ spare cash flow may become negative – putting some of them at risk of default. Remaining options would include reducing/eliminating discretionary spending to levels that are likely unrealistic – or selling up. Considering consumer spending accounts for around 50% of economic growth, this would have a damaging impact on the economy. 

For every 100 basis rate increase, it is estimated that there is around 10-15% decrease in consumers purchasing power. Compounding the impact even more, inflation at 7.8% in the December quarter is outpacing income growth at 3.1% in the September quarter, further reducing consumers purchasing power. 

A glimpse of the beginning of these stresses that consumers will be forced to endure was evident in the slowing retail growth and increased competition among discounting practices seen in JB Hi-Fi’s quarterly results on Monday. The company admitted consumer spending has started to slow.

The RBA’s unprecedented $188 billion emergency loan program that gave banks the cheapest liquidity in history at between 0.1-0.25% are due to start being paid back next month. Fixed interest home loans jumped to 46%, up from the pre-pandemic level of 15%. Around half of these loans are due to convert into the variable interest structure this year as well. New dwellings commenced in the September quarter were down 17.73% from a year earlier.

Coolabah Capital Investments’ Founder and CIO Christopher Joye, who developed the model that CoreLogic uses to map national house prices, has been predicting a 10-25% decline in house prices eventuating in 2023 since at least October 2021 – while the RBA was still claiming it would not raise the cash rate until 2024. With the 5 city capital index now down 9.2% on an annual basis, and money markets pricing in a terminal rate of over 4% – his touted “real interest rate hammer” could be yet to fall.

The RBA’s Financial Stability Review (October 2022) cautions that the future of household consumption is subject to considerable uncertainty, and that the outlook for financial stability over the coming years hinges largely on households and businesses ability to weather challenging economic conditions. 

Given Australia is nearing the indicated peak of its rate cycle, whether or not house prices and consumer spending continue to fall depend on how long the RBA maintains the terminal rate, and when they start cutting. If inflation data starts to genuinely buckle, monetary policy will be swift to react. If it happens this year, it could mean that the housing market is nearing its trough and may stabilise. After all, the biggest recorded drop in Australian housing since records began around 42 years ago was 10.7%, which occurred between 2017 and 2019. Banks are better capitalised than ever before, and the Australian Prudential Regulation Authority has stated it is open to reducing the 3% serviceability buffer used to stress test mortgages (which would increase borrowing power) if that is what’s required to induce an upward correction in credit growth and house prices. 

Ultimately, this is a delicate situation that is of course being closely monitored. It’s a good thing the RBA meets monthly.