The doom and gloom talk about mortgage rates and mortgage stress is overdone for the Australian market, at least for the reasons it has been quoted for.

Let me start with some simple ways to predict the movement of interest rates and property prices for a market economy like ours.

Money is very intelligent; it always finds its way to a better economy to get more return (i.e. higher interest rate and more expensive local currency).  The recent interest rate rises are a direct result of our buoyant economy.  Because the underlying Australian economy is very strong our currency has appreciated against the US dollar which has already eased the upward pressure on interest rates to a certain degree; otherwise we could have seen interest rates rise even higher.

A percentage of what we earn always goes towards paying for our accommodation, whether it is through rent or a mortgage.  Even if you own your own home, in a way you are still paying for it by the opportunity cost of the money tied up in your home equity.

A free market economy is very clever.  It always somehow makes businesses and individuals pay the right proportion of its earnings for accommodation.  Even if you may only have a job, you are still paying your fair share for accommodation just like a business paying to rent the premises it operates from.

This is the reason why we usually see property prices go up when people are making good money and unemployment is low.  We are being ‘taxed’ accordingly for our accommodation.  A lot of people worry about the upward wage pressure which can cause higher inflation, but higher wages are the foundation of appreciating local property values.

As a home owner or property investor, you would prefer to have higher wages so that you can afford the property and its mortgage repayments.  So, if money is to look for a better return in Australia, you would prefer it to go for higher Australian dollars rather than higher interest rates.

If the Australian economy continues to be strong, I would be surprised to see interest rates come down any time soon, and I would expect that property prices will continue to go up too.

In my opinion, interest rates may not need to go too much higher because it is already high enough compared to most of the developed countries. Higher mortgage repayments have already taken a bigger portion of our earnings.  There will be less earnings left to be ‘taxed’ through higher property prices, hence the growth of property prices will eventually slow down if interest rates remain at high levels long enough.

The critical question is whether our economy can sustain the current kind of growth? And if so, for how long?

Amongst many other things, I believe the future of our economy relies on the balance of the following 3 key factors:

1) Whether the Australian economy can decouple from the US economy.  I believe the US is already in recession. We will see a clearer picture after their federal election, towards the end of 2008.

The US economy will go into structural decline over the next decade due to baby boomers retiring and the slow down of productivity growth from technologies.

The more we rely on the US economy, the more likely it is that we will go into recession with them in the near future.  If we fail to decouple from US economy, we will go into recession with them, maybe with a time lag of one or two years.  In this case, interest rates will fall, and so will property prices.

2) Whether the Australian economy can align itself quickly with booming Asian economies such as China, India and Japan.

Asia will be the world’s engine of the next decade.  Australia is one of the few developed countries that are in the same time zone. This gives us a distinct advantage because distance can be ‘shortened’ by broadband technology in the near future.

Unlike the US, Australia is a relatively small country in population, which makes it easier for us to leverage other countries to get out of trouble.

In my opinion, the majority of the developed world will go into severe recession for the better part of the next decade due to the structural decline of the productive work force and the technology cycle.  Australia may be relatively well positioned the best to avoid this threat.

3) How well the global financial market handles the current credit crisis.

I have remained sceptical about the real reason and motive of the sub-prime mortgage crisis.  Sometimes it looks to me like an excuse to start a worldwide credit crisis for the purposes of mass wealth transfer.

Money is always transferred from the uninformed to the well informed during any financial crisis.

Turning off the credit tap is a mechanism many financial institutions use to protect them selves and corner others.  When the few most influential financial institutions are doing it at the same time and for a long enough time, the impact on the world can be significant.

If the big players in a global financial market work together, they can move the market and restore confidence, and get us out of the current credit crisis quickly.  The question remains whether they will benefit more financially to see this crisis worsen.

In regards to what we should do, there are two scenarios:

1) The worst case scenario is that Australia eventually goes into recession with the US.  I believe that we may still have one or two good years ahead of us, where banks are going to continue to increase their interest rates, albeit slowly, and property prices will continue to go up modestly over the next 2 years.

If you already have a mortgage, you may want to fix your interest rate for up to 2 years, then move on to a variable rate as interest rates will come down.

If you are comparing buying against renting, knowing that interest rates will remain high and that you may only have a window of 1 to 2 years of capital growth before a drop in property prices, renting may be more cost effective.  You can then buy when the property price drops to a lower level later.

2) The best case scenario is that Australia escapes from recession in the next decade.  We will see interest rates remain high and property prices continue to go up steadily.  Regardless of how well Australia aligns itself with Asia, the impact of a world wide recession will still slow us down.

In other words, even if we don’t go through a severe recession, our economy boom will slow down, hence we won’t see interest rates go too much higher.  Because banks are now moving their interest rates up ahead of the Reserve Bank, if you find a good fixed rate that is reasonable and you are not looking at refinancing your property to release more equity in the near future, it would be a good idea to fix it for a few years.

If property prices continue to rise, renting may not be the best option as rents will go up as well and you are not any closer to home ownership and you may not be able to buy your home at the current price level in the future.

In summary, while we have looked at the external forces which can affect our decision, it is also important to remember that our internal beliefs can also affect our external reality.

After you have provided for the worst case scenario and put in place the appropriate contingency plan, you may want to consider moving your focus away from this scenario.  This is similar to buying car insurance. Once it is in place, you should stop worrying about running into someone else’s car all day long.

It is often true that ‘what you believe is what you get’.  The more you believe in a positive financial outcome, the more likely it is that you will move towards better financial decisions intuitively.