We’re in the final innings of the modern world’s greatest economic experiment…
America’s rampant credit expansion and subsequent implosion in the late 2000s almost brought down the entire global financial system. Radical monetary policies were initiated in 2008/2009 by global central banks to address the disaster. And just now, almost a decade later, those emergency policies are starting to be unwound. The financial surgery that was quickly delivered in 2008/2009 and the ensuing long recuperation is almost over. Or so it seems…
The economic medicines delivered after the crisis were previously untried and did not deliver the results expected. Growth has been much slower to recover than anticipated. And the expected rise in inflation that would have allowed central banks to revert to “normal” interest rate policies simply hasn’t happened.
So what’s happened?
Driven by historically low interest rates, financial asset prices around the world have hit record highs in many asset classes – bonds, stocks and real estate. In the case of real estate, many governments and central banks have initiated measures aimed to cool down overheating property markets. Hong Kong, China, and Singapore have aggressively used such cooling measures.
So, when we look back on the past decade, owners of financial assets in many markets around the world have done very well. Middle-income wage earners, pensioners, and others living on fixed income, dividends or interest payments have done relatively poorly. Low interest rates have benefitted owners of financial assets.
But U.S. interest rates are rising… and they’re set to rise by a further 75 basis points this year, according to market consensus. And the latest data and market reactions are signaling that rates may rise by more than this as inflationary pressures pick up in the U.S.
And U.S. interest rates don’t just affect the U.S…
How rising U.S. interest rates will affect Hong Kong
Because the Hong Kong dollar is pegged to the U.S. dollar, Hong Kong “imports” U.S. monetary policy. The Hong Kong Monetary Authority (the equivalent of the Federal Reserve) is tasked with maintaining the peg, so Hong Kong must follow U.S. interest rates.
This ensures that Hong Kong asset prices, particularly real estate, will be more volatile than most other markets.
Hong Kong cannot raise and lower its interest rates to control its own domestic inflation or rising/falling asset prices.
And because U.S. interest rates may not match what Hong Kong markets need, it is almost inevitable that at times, interest rates will be lower than needed – which will help push asset prices higher.
Or rates may be higher than needed, which can exacerbate downturns and recessions.That was Hong Kong’s fate during the almost six years of downturn following the 1997 Asian financial crisis.
And volatility in asset prices means potential volatility in overall economic performance.
What does this mean real estate?
Conventional economic thinking tells us that rising interest rates is negative for real estate prices, and that falling rates will push property prices higher. But it’s not that simple. There have been many cases over the years in Hong Kong where falling rates have been accompanied by falling property prices – and vice versa.
Over the years, REAL interest rates – not nominal interest rates – are a better predictor of real estate asset price performance. (The real interest rate is the nominal rate adjusted for inflation. For example, if inflation is 3 percent and the interest rate is, say, 2.2 percent, then the real interest rate is minus 0.8 percent (2.2 percent – 3.0 percent = -0.8 percent).)
Over many years, when the real interest rate has been very low, or negative, the real estate markets have tended to rise. And when real rates are significantly positive, that is rates are higher than inflation, property prices tend to suffer.
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This pattern has been evident in other markets as well, such as Singapore and, to some extent, China. It has been less the case in Japan, where perennially low interest rates have been the norm for more than 25 years.
Hong Kong has experienced low to negative real rates for almost a decade. So it is little wonder that there has been substantial upward pressure on real estate prices.
So what is the outlook for interest rates – and the Hong Kong economy?
Markets agree almost unanimously that the U.S. Federal Reserve has at least three interest rate hikes in store for us this year.
If Hong Kong banks follow suit, that would likely lift the Hong Kong three-month interbank rate (HIBOR) from around 1.25 percent today to around 2 percent by year end. This is the base rate that much borrowing is priced off. This is still very low by long-term history in Hong Kong, and with inflation running at a little below 2 percent, real rates in Hong Kong will still remain very low following this increase.
So interest rates, on their own, are unlikely to produce a crash in Hong Kong’s real estate markets or its economy. But this increase may dampen buying enthusiasm and slow the rate of price increases, or even produce a modest downturn. This could slow the domestic economy. Hong Kong (and China) is in its third real estate cycle since the global financial crisis. Most other developed countries are still in their first post-global financial crisis cycle.
But real estate crashes are normally associated with high levels of leverage, either held by developers or by property buyers. Leverage within Hong Kong is not going to lead to a crash in Hong Kong’s property market or its economy. Hong Kong’s major property companies are the most lowly geared amongst their peers worldwide. (This is not the case in China). And average loan-to-value ratios in the Hong Kong housing market are around 50 percent. This means that there is a very sizable equity cushion available to banks and borrowers. There is little systemic risk attached to interest rates, real estate markets and the financial system in Hong Kong.
What about other countries?
Other countries are also hugely influenced by the U.S. For example, most countries in the Asia Pacific region (perhaps with the exception of Japan) dance pretty closely to the tunes of the U.S. economy and its interest rates.
For example, Singapore maintains a “dirty peg” to the U.S. dollar. It is theoretically some kind of trade weighted basket approach, but its methodology is not disclosed.
The reality is, in the present environment, it is highly unlikely that a meaningful rise in interest rates in the U.S. would not be met by interest rate increases in the major economies in this region. It may not be as direct as for Hong Kong, but it is unlikely that interest rates in the region would go against the U.S. trend.
But again, for most countries, real interest rates are a more reliable guide to hard asset prices, such as real estate. For most countries, a 50- to 75-basis point (that is, 0.5 or 0.75 percentage point) rise in interest rates will not produce unusually high real interest rates in the current environment.
But for some markets, real estate asset prices are already under some pressure from domestic cooling measures and higher costs of borrowing, or restrictions on borrowing. This is likely to continue in the coming year. Markets in parts of Australia and New Zealand, as well as countries like Taiwan and Malaysia, are also likely to see some tightening of real estate asset prices over the coming year.
Singapore is in a slightly different position. Its residential market has already suffered a decline of around 12 percent over the past three years. It is poised for some recovery as oversupply has been absorbed. But rising rates may limit the scope of the upside that we expect to see in that market in the coming year.
Here’s what we really need to worry about…
Looking further out into 2019, it is not going to be rapidly rising interest rates that we have to worry about. It will be the prospects for a new slowdown, and possible recession in the U.S.
Well, bond markets are usually a better guide to medium-term prospects for the economy than equity markets. And the U.S. bond markets are warning us of an impending slowdown coming down the track.
The key here is the spread between yields on long-dated government bonds and short-dated bonds. When that spread is narrow, or even negative (i.e., if longer-term rates are LOWER than short-term rates – an inverted yield curve), then the market is telling us that expectations of rapid growth and inflation in the medium term is very low.
The interest rate spread is currently still positive, but it is unusually low. That is telling us that markets do not expect a sharp rise in inflation that would justify sharply higher interest rates. So the chances are that the three anticipated interest rate increases that are currently baked into the U.S. economic cake are all we will get.
Every U.S. recession in recent history has been preceded by an inverted yield curve, where rates on long dated bonds are lower than those on shorter dated bonds.
While the current yield curve is not inverted, it is unusually flat. This does not suggest impending doom for the U.S. economy, but it’s certainly flashing a warning signal. So interest rates are not going to soar anytime soon to life threatening levels in the U.S., and therefore in Hong Kong.
A new U.S. recession in the coming two years is a greater risk for markets like Hong Kong than soaring interest rates in the near term. That is likely to be the problem we will be grappling with by 2019.