It all comes down to inflation

There is mounting evidence to suggest that Australia’s housing market rests at a critical juncture. The first two charts below show the evolution of Australian dwelling values since 2000 and 2006, respectively. You can clearly see the latest innovation in the housing cycle, wherein overall Australian home values (blue line) have tapered by a modest 2.3%. The question on everyone’s lips is: what lies in wait?

Before I address this, it is interesting to inspect the charts more carefully. Observe, in particular, how Sydney dwelling values have massively underperformed the rest of the Australian market over the last 11 years or so (black line, first chart). It is also fascinating to note that even though the Perth and Brisbane housing markets have suffered 7.5% and 5.9% declines in the past year, they have actually been our two best-performing conurbations over the past 11 years.

In my opinion, the near-term destiny of Australia’s housing market very much depends on next week’s second-quarter inflation numbers. If inflation is low, the RBA will likely be on the sidelines for the rest of the year. It can argue that it was vindicated for not responding to the very high first-quarter results, and will in any event be downgrading its economic growth forecasts for 2011, which were always on the high side.

Talk in the media will galvanise more firmly around rate cuts. Consumers will start to scale back their still extraordinarily hawkish interest rate views (see chart below), with 84% anticipating rate hikes. Given the average Australian thinks he will be hit by two or more rate hikes in the next 12 months, it is no surprise that underlying economic conditions have been so soft.

In this low-inflation scenario with no future hikes and the prospect of cuts, our forecasting models predict that Australia’s housing market has the ability to start grinding out very modest capital growth, which, of course, should be complemented by healthy rental returns (see next chart).

In the less favourable alternative, where inflation next week is reported high – at, say, 0.8% for the quarter or more – it saddens me to say that our beloved central bank will be very much on the interest rate warpath. That means the likelihood of a rate hike, or hikes, before the year is out. And the half-nelson that the RBA currently has Australia’s housing market in will only tighten. 

These crossroads are best illustrated by the divergence of beliefs between economists and the financial markets. The following chart shows ANZ’s interest rate forecasts contrasted against the futures market’s expectations. Whereas the futures market is predicting rate cuts, ANZ thinks we will get hikes.

Who is right? We cannot tell at this point. It all depends on inflation. So, if you are looking to buy but have not found a place yet, you should be hoping for a high inflation outcome, which will inevitably result in persistent, interest rate-induced pressure on prices. If, on the other hand, you are looking to sell, you should be praying for a low number next week.

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. You can follow Christopher on twitter at @cjoye or read his blog.