House prices in Sydney and Melbourne: interest rates could lead to a record correction

If the Reserve Bank continues to raise the cash rate, Sydney and Melbourne are looking at their biggest house price corrections in living memory.

Earlier this month, the Reserve Bank of Australia (RBA) plunged a dagger into the hearts of mortgage holders by raising the cash rate by another 0.5% – the third consecutive monthly increase.

Home values ​​in Australia’s five major capital markets began falling shortly after the RBA’s initial 0.25% rate hike in May and have so far fallen around 2% from its peak, according to CoreLogic.

The decline at the five-city aggregate level was led by Sydney and Melbourne, where quarterly values ​​fell 3.5% and 2.3% respectively, more than offsetting growth in smaller markets:

AFR The latest survey of 31 economists revealed a median forecast for the official exchange rate (OCR) of 2.85% by the middle of next year. If true, Australia’s OCR would rise another 1.5% from its current level.

The futures market remains even more hawkish, tipping a peak OCR of 3.5% by May 2023.

If either interest rate forecast materializes, Australian mortgage rates would soar. Australia’s average discount variable mortgage rate would climb to 6.2% according to economists’ forecast (dotted red line below) and 6.8% according to market forecast (solid red line below) :

The market’s OCR forecast would mean that the variable discount mortgage rate would climb to roughly double its level (3.45%) before the start of the RBA’s tightening cycle.

Either way, Australian mortgage holders would face massive increases in repayments, putting many borrowers in serious financial trouble at the same time as their property values ​​plummeted.

In its latest Financial Stability Review, the RBA estimated “that a 200 basis point rise in interest rates from current levels would lower real house prices by around 15% over a two-month period. year “.

Therefore, the economists’ forecast of 2.85% OCR suggests a peak-to-trough fall in real Australian house prices of around 20%.

According to RBA modeling, the futures market forecast of 3.5% OCR would cause Australian house prices to fall by around 25% in real terms.

Sydney and Melbourne would likely face even bigger price drops than the national average, as they are the most expensive housing markets with the most indebted households.

As shown in the following chart, house price to income ratios for NSW (read: Sydney) and Victoria (read: Melbourne) are much higher than other Australian jurisdictions:

Sydney and Melbourne are also the most expensive housing markets in the country relative to rents, as illustrated by their anemic gross rental yields of 2.7% and 2.9% respectively, according to CoreLogic:

Their extreme valuations make Sydney and Melbourne more susceptible to RBA rate hikes, meaning their prices are likely to fall more than the national average according to economists’ or futures market’s OCR forecasts. The fact that these two markets are leading the current downturn is proof enough.

Mortgage holders in our two biggest cities are hoping that neither the economists nor the market are right, and that the RBA stops well before its monetary tightening.

Otherwise, Sydney and Melbourne are eyeing their biggest price corrections in living memory.

Leith van Onselen is Chief Economist at MB Fund and MB Super. Leith previously worked at Australian Treasury, Victorian Treasury and Goldman Sachs.

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