Here's how US interest rate hike could hurt Hong Kong property stocks

Do interest rates matter, in the first place?.

An unexpected decline in US interest rates in the form of the US 10-year bond yield has been one of the key positive surprises for Hong Kong property stocks in 2014.

According to a research note from Barclays, while the timing and magnitude of a US interest rate increase remains a source of debate, with every passing day the event is getting closer. Therefore, it must be noted how the Hong Kong housing market is likely to react to the first rate hike and the question is raised: do interest rates matter?

Firstly from a numerical standpoint, a 25bps increase in mortgage rates would only increase monthly mortgage payments by 2.3%. If one were to use the latest median Fed Funds forecasts (1.375% by end-2015, 2.875% by end-2016 and 3.75% by end-2017), this would imply that the Fed Funds rate would be raised by 125bps by end-2015, 275bps by end-2016 and 363bps by end-2017.

Here's more from Barclays:

Holding all else constant, if we were to factor in these increases to Hong Kong’s mortgage rate, this would suggest that monthly mortgage payments would rise by 12.0% to 37.1%, assuming a 20 year mortgage.

If we were to instead base the above analysis on a 25 year or 30 year mortgage, the increase in monthly mortgage payments would be more significant with the monthly payment for a 30 year mortgage potentially rising by 54.9%. (The latest average contractual life of new mortgages in August 2014 is 25.9 years).

Some may argue that since these interest rate increases are spread over three years, at the early stage of the cycle, say in 2015, as rates may only rise by 125bps, the 12% increase in monthly mortgage payment is unlikely to be deterrent for potential home buyers.

On this point, we would disagree. We believe the issue is one of visibility. While the first 25bps increase in mortgage rates would only have a negligible impact, no one knows whether that first 25bps increase is the first 25bps out of 75bps or the first 25bps out of 275bps.

Without the visibility of where interest rates may peak out, we believe some home buyers are likely to take a wait and see attitude. We believe that once there are signs that the interest rate hike cycle starts to peak out and providing affordability remains intact, at that point, these sidelined home buyers would re-engage.

In fact, when we look back to the last rate hike cycle back in 2005-2006, we saw this precise impact on market volumes. Back in March 2005, just prior to mortgage rates first increasing from 2.3% to 2.5%, Hong Kong had enjoyed 12,900 private housing sales.

But as rates increased, this dropped to a low of 3,649 transactions in November 2005. It was not until the market began to sense that the series of interest rate increases were peaking out that home buyers re-engaged and volumes then rebounded back to the 6,000-7,000 level.

Interestingly, when we consider the 1999-2000 rate hike cycle when Hong Kong’s prime rate went up from 8.25% in July 1999 and peaked out at 9.5% in May 2000, private housing sales volume remained very muted even as mortgage rates declined as a result of a widening of the mortgage yield spreads.