Interest Rates & Investing for Income

As we all know, the Reserve Bank (RBA) has dropped the official cash rate to an all time low of 2.50%. And for those relying on income from cash or term deposits, it’s really beginning to bite.  Make no mistake, if you are retired and relying on the returns from interest rates, the RBA does not care about your plight.

The following excerpt comes from the RBA website:

‘It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank … are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:
a.       the stability of the currency of Australia;
b.       the maintenance of full employment in Australia; and
c.       the economic prosperity and welfare of the people of Australia.’

What this means is that that the RBA will use interest rates as a tool for managing economic growth.  And to simplify what they do, they will raise rates to cool growth when things are looking overheated, and they will lower rates when growth is slowing in an attempt to stimulate the economy.

So why have they been dropping rates over the past two years – well the answer is two fold:

1/ The first reason is the Reserve Bank knows that the mining boom is waning and they need other parts of the economy (read, building and construction) to pick up the slack so that unemployment does not get out of control.   As miners lose their well paid jobs and move back to their home towns permanently, the Reserve Bank is counting on the fact that low interest rates will encourage both households and companies to borrow, build and expand.

Whilst it is very early days we are yet to see much evidence of a pickup in building and construction, and to be fair these things take time to turn.
There would certainly be many companies waiting on the election result and some political certainty before committing capital to large projects.

One thing you can be sure of is that the last thing the RBA wants is another property boom.
In fact I believe the effects of the GFC will be longer lasting and if it has taught us one thing, it is that carrying too much debt is not a good thing.
Australian’s are now and will continue to be in a deleveraging cycle, and this can be seen with household savings rates at the highest level in two decades at around 10%

2/ The second reason for lowering rates is that the high Australian Dollar (AUD) is not be good for our terms of trade or manufacturing sector, as it makes our goods more expensive overseas and makes imports cheaper.  Therefore, in lowering interest rates the RBA hope to make Australian debt markets less attractive for foreign investment, hence they will sell the AUD and take their capital home (selling the AUD in the process).

A little known fact is that the AUD (the ‘little Aussie battler’) is now the sixth most traded currency in the world.
Australia just need to look to countries like Japan who have deliberately embarked on an exercise of devaluing their currency (the Yen), simply to make their export market more competitive globally, in an attempt to reinvigorate their economy.

So what does this all mean for mum and dad investors – for one, don’t expect any real return on cash for some time yet.
Whilst the RBA will more than likely sit on their hands to monitor the effects of low interest rate settings, the general consensus is they will stay low for quite a while.

The outcome of this is that people are forced to look to other asset classes (read shares) for higher income returns.
And this has been a large reason as to why the Australian share market has been performing so well of late, as investors chase yield.

The performance of the banks and Telstra over the past twelve months is a perfect example of the rotation out of low yielding deposits into high yielding shares.
However, this won’t always be the case and should long term bond yields increase then expect a rotation back the other way.
(i.e. the Telstra share price is negatively correlated with Aust 10 year bond yields – that is when bond yields are increasing it is bad for Telstra’s share price and vice versa)

As always, the old adage of diversification and not having all of your ‘eggs in one basket’ will always be true.
I call it the ‘sleep test’.  That is if your portfolio is keeping you up at night, then perhaps you know something is wrong and you need to do something about it!

Brett Martin is a senior financial planner and owner of Bridges Financial Services in Coffs Harbour.

Image compliments of Stuart Miles and freedigitialphotos.net

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