Interest rates: the honeymoon’s over

The Reserve Bank of Australia (RBA) lowered interest rates to emergency levels during the now infamous Global Financial Crisis (GFC). The cash rate fell nearly 50% to a generational low of just 3.00% in April 2009. As a result, many Australians have enjoyed increased affordability for home and investment loans, and employers have been able to retain workers during the downturn.

But nothing lasts forever, and the honeymoon is well and truly over.

Interest rates are fundamental indicators of the health of financial markets. In moderation, rising rates are a positive sign. During the GFC, Australia’s historically low settings enabled us to weather the global economic storm.

This approach is still being used by other countries, with official interest rates at the time of writing just 1.00% in Europe, 0.5% in the United Kingdom, and 0.25% in the United States. The economies of these regions were more seriously affected than Australia’s economy, and they continue to struggle with difficult financial circumstances.

As economic conditions improved over the second half of 2009, the RBA began the process of ‘tightening’, or increasing, interest rates. This was done to ensure public enemy number one – inflation - does not run out of control. In late 2009, three monthly increases in a row were announced, a scenario not seen since the 1980’s.

At its Board meeting on 2 February, the RBA left the cash rate unchanged at 3.75%. This surprised financial markets, and signalled some concerns about the strength of the current recovery. However, many commentators believe that interest rates will continue to rise over the course of 2010. If the Australian economy recovers as expected, further hikes will gradually move rates to a more ‘normal’ setting of between 5.00% and 5.50%.

What does it mean for me?

A rising interest rate cycle has many implications for households, businesses, investors and retirees. As interest costs increase, the disposable income, and thus the spending power, of households is reduced. Corporate profits are also constrained by higher interest rates, and property investors require more cash flow to service loans.These scenarios suck money out of the economy and slow economic growth. For example, current home loan rates are approximately 6.00%. If the RBA increases official rates to the long term average of 5.00% to 5.50%, the flow on to you, the consumer will be rates of 8.00% to 9.00%, significantly adding to mortgage costs.

For investors in shares, a rising interest rate cycle confirms that a recovery is under way, with improved company earnings offsetting the added costs of borrowing money. Increasing interest rates are only a major problem for shares when rates are raised aggressively, and reach levels well above normal. This was the case in 1994 when rates increased from 4.75% to 7.5% over four months.

Rising interest rates are not all bad. They provide increased returns for investors and retirees who rely on cash and fixed interest income for living expenses. Currently term deposits pay 5.00% to 6.00% for six to eight months, with higher returns available for longer terms. Cash and fixed interest investors have seen their disposable incomes reduced substantially over the last 12 to 18 months and will welcome this stage of the cycle.

Please contact your adviser if you have any questions or concerns about how the current interest rate environment will affect your financial circumstances, and to ensure your affairs are structured to manage the changes ahead.