Something doesn’t feel right.

Maybe it’s me.

This week, the Reserve Bank of Australia (RBA) kept interest rates on hold at 4.75%.

No surprise there, of course, as every economist in the land had predicted no change, including us here at The Motley Fool on our Twitter feed.

The accompanying statement from RBA Governor Glenn Stevens was incredibly dull, stating the bleeding obvious.

Yes, we have a commodities boom, but inflation seems under control.

Yes, natural disasters, particularly the Queensland floods and the Japanese earthquake, have crimped growth, for now anyway.

Yes, the average consumer (i.e. not the 24 year old mine-workers earning over $200,000 per annum) is saving money, and not spending it.

Yes, unemployment remains at just 5%, with leading indicators suggesting further growth in jobs, albeit at a slower pace than 2010.

And yes, the high exchange rate is having a cooling effect on the economy.

Put all those things into the RBA cauldron, stir, add a pinch of iron ore, a dash of rare earths, a slug of coal, inject a large dose of LNG, and voila, you get inflation over the year ahead running between 2 and 3%.

Interest Rate Hell

So what does it mean for interest rates?

As usual, there are differing opinions.

Some, like HSBC economist Paul Bloxham, predict interest rates would be raised to 5.25% by the end of the year, and reach 5.75% by mid-2012.

Ouch. If these predictions came true, big 4 bank variable mortgage rates would jump from today’s 8% to 9%.

For an already over-valued housing market, and for thousands of already stressed home owners, how will they cope with their monthly mortgage repayments jumping yet higher again?

Housing Bears

It’s no secret The Motley Fool is bearish on the Australian housing market. Sure, property has had a great run, and many people have made a killing over the last 20 odd years in property.

But the recent past simply cannot be replicated. When we see future expectations of 10% per annum from the property market into perpetuity, we cringe.

Australian houses are unaffordable today. You can give us all the twaddle you like about housing shortages and demand always exceeding supply, but if you can’t afford the mortgage, you can’t afford to own a house. Simple.

The property bulls will counter by saying more people will therefore need to rent, keeping demand for property high, and therefore keeping property prices at their elevated levels.

Maybe. But why would anyone want to buy an investment property today? The yields are paltry, somewhere around 3.5%.

Which nicely brings me back to interest rates…

It’s A No Brainer

If, in the coming 12 months, the RBA does increase the cash rate a full percentage point to 5.75%, it’s going to make those rental yields look even more derisory.

What would you do? Borrow a whole heap of money, buy an investment property, and ‘enjoy’ a rental yield of 3%, or stick your cash in the bank and enjoy a return of 6.5% or even more?

It’s a no brainer if you ask me…unless of course you think house prices will keep going up by 10% per annum for ever more. If you’re in that group, I can only say good luck, for the increasing evidence is that house prices will go down in the medium term, and not up.

Much Worse Than 2008

A recent post by Delusional Economics on Macrobusiness makes for some interesting reading, particularly the comments from Stormboy, someone who works for a big 4 bank lender in Queensland…

…The valuations are down for the whole market from million dollar homes to small homes in the outer burbs. We have three real estate agents who are in serious financial difficulty and the bank is doing everything it can to keep arrears levels low. The slow down became most evident just before Christmas and has gotten worse in last three weeks with a small uptick this week. I have been in banking and this company since 1989 and this is much worse than the slow down in 2008.”

And then there’s a story in this week’s Australian Financial Review starting with…

Loans for the purchase of new homes have virtually collapsed as first home buyers desert the market under pressure from higher interest rates.”

It Just Don’t Feel Right

Meanwhile, the larger economy trundles on as if it doesn’t have a worry in the world. Unemployment has now dipped below 5%, the Aussie dollar approaches US$1.05, the gold price is at a record high, and oil is at a 30-month high.

Do you see what I mean when I say something doesn’t feel right?

All the macro signs point to higher inflation and therefore higher interest rates. But out in the real world, in the mortgage-belts of Sydney, Melbourne, Brisbane, Adelaide and even Perth, consumers are hurting now.

The Mother Of All Housing Bubbles

Higher interest rates will put many over the edge, and once and for all deflate the mother of all housing bubbles.

But in the meantime, as Citigroup’s ex CEO Chuck Prince said just before the U.S. sub-prime crisis hit…

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Boogie on, for now. But change is ahead…

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