The great house price correction has begun: the all-regions (metro plus non-metro) national dwelling value index published by CoreLogic declined by 0.1 per cent last month, which is the first time it has fallen since the short-lived, pandemic-induced correction that ended in September 2020.

The real devil is in the detail, however, with much larger losses being recorded by Australia’s two biggest cities, Sydney and Melbourne, where home values declined by 1 per cent and 0.7 per cent, respectively, in May alone. Unsurprisingly, dwelling values also fell in contiguous Canberra, albeit by 0.1 per cent only.

Sydney dwelling values have now dropped 1.6 per cent since their technical peak in February (the market started flatlining in November 2021). Home values in Melbourne have also corrected almost 1 per cent since their own January apogee.

In past cycles, we have seen the vanguard cities of Sydney and Melbourne lead the way. This is, once again, the prevailing dynamic: dwelling values in Brisbane, Adelaide, Perth, Darwin and Hobart continue to climb, although the Brisbane boom does appear to be grinding to a halt.

There have been a number of key drivers of the great Aussie house price correction. First, there has been a massive increase in fixed-rate borrowing costs, with the typical, three-year fixed-rate jumping from circa 2 per cent one year ago to 4.5 per cent.

This process commenced in November as a result of the Reserve Bank suddenly dropping its commitment to not raise interest rates until 2024, and its so-called yield-curve target whereby it kept the interest rate on the 2024 government bond at 0.1 per cent in line with its target overnight cash rate.

A second driver has been market perceptions that the RBA would start raising rates this year, which penetrated the popular consciousness in late 2021 after the RBA dumped its forward guidance about not lifting off until 2024. A series of increases this year were fully priced by markets in November 2021, which was widely communicated by the media.

A third headwind has been the RBA commencing its monetary policy normalisation process with an inaugural 0.25 percentage point cash rate increase in May 2022 (one month ahead of the explicit plan it outlined in April, which targeted a first rise in June), resulting in variable-rate home loan costs increasing by the same margin.

A fourth factor has been RBA governor Philip Lowe advising the public in May that he expects to lift his target cash rate to at least 2.5 per cent, which would mean that discounted variable-rate home loan costs will rise from circa 2 per cent before the RBA’s May increase to 4.5 per cent once the cash rate hits 2.5 per cent.

Financial markets have a much more aggressive view: they are pricing in a terminal RBA cash rate of 3.7 per cent, which would imply that discounted variable-rate home loans will increase to 5.6 per cent.

Finally, there has been a generic increase in lenders’ funding costs. This includes both banks and non-banks. Funding costs were unusually low as a result of the RBA lending the banks $188 billion at a super-cheap cost of between 0.1 per cent and 0.25 per cent annually. This facility is no longer available and will have to be repaid over the next few years.

Funding costs have, as a consequence, started to mean-revert, and it is reasonable to assume that some of these expenses will be passed on to borrowers in the form of out-of-cycle hikes imposed by lenders. These should, however, be neutralised by the RBA: any extras that lenders pass on to borrowers are increases the RBA will not need to impose itself (given the RBA is practically targeting a given level of borrowing rates).

Last October, we expected at least another 5 per cent worth of capital gains at the national level before the Aussie housing market started to roll over (CoreLogic’s index delivered 5.4 per cent between 1 November and 30 April).

We argued that after the RBA begins lifting rates in mid-2022 at the earliest (having planned to kick off in June, they got the yips and started in May), the first 100 basis points of rate increases would trigger a subsequent 15-25 per cent correction in national home values. This would be the largest draw-down on record. Care of CoreLogic, we now know that the great Aussie housing correction has indeed begun.

Although capital losses might suck for homeowners, they have banked capital gains of 37 per cent since the RBA first cut its cash rate below 1.5 per cent in June 2019 (it is currently 0.35 per cent after the 0.25 percentage point hike in May).

If we are right and national values correct 15-25 per cent over the coming years, it will be modest payback in the scheme of things.

We further believe this correction will be orderly given the overall strength of the economy, which is likely to be supported by a number of factors.

These include: a low and competitive Aussie dollar, helping exporters and import-competing industries; very strong population growth, powered by skilled and unskilled migration, which will drive aggregate demand; a revolution in business borrowing as companies seek to invest in their productive capacity, given ongoing supply-side constraints coupled with a huge increase in re-shoring of supply chains as economies decouple from China; elevated prices for all of Australia’s key exports, including agriculture, iron ore, natural gas, and coal; and ongoing fiscal stimulus as a result of structural deficits at the federal level, which are being reinforced by the need to spend vast sums on national security, and robust infrastructure investment programs from both the Feds and the states.

One dynamic that is not especially well understood is how the public purse profits from inflation. In the case of the states, they capture GST revenue, which is a direct inflation tax. They also earn payroll tax revenue, which is a wage tax. Obviously, the Feds get the benefit of income taxes that climb as wages rise.

Upside surprises to tax revenues are a key reason why federal and state budget deficits have been massively revised down for the current financial year, as we long expected.

There is also no shortage of demand for government debt securities, as Victoria underlined with a record new bond deal on Thursday. Treasury Corporation of Victoria launched dual-tranche 2028 and 2030 floating-rate notes that attracted an unprecedented $8.1 billion of demand, allowing TCV to ultimately print a record $4.4 billion across the two FRNs (we bought both).

This was a smart trade: Victorian taxpayers are paying only circa 1.3 per cent annual interest on the FRNs compared with the 4.2 per cent they would pay on a normal 10-year fixed-rate bond. Judging by what taxpayers are doing with their own money, it is also what they want: almost all new home loan approvals today are for discounted floating-rate mortgages that cost 2.25 per cent, half the price of the typical three-year fixed-rate loan that charges 4.5 per cent annually.

The key investors in the FRNs were banks, which will need to buy between $315 billion and $570 billion of government bonds over the next 2.5 years to meet the regulator’s liquidity requirements. Although there had been some debate as to the magnitude of bank demand for government bonds, TCV’s transaction put that subject to bed.SI