Interest rates: Lower for (even) longer

investment strategy

Investment managers discussing recent RBA interest rate cuts

By

Paul Ashworth, Managing Partner
David Clark, Director
Campbell Cooke, Senior Analyst


Posted 21 June 19

The Reserve Bank of Australia (RBA) cut interest rates by 0.25% to 1.25% in June, ending a 33-month streak of inaction – the longest in RBA history.

This move sets the standard for monetary policy over the next few years as lower for (even) longer, with significant implications for asset prices, savings income and capital market ‘normality’.

Cameron Harrison’s position for the last four years is that the Australian economy has ‘eked out’ economic growth but at a serious long-term cost. Central to our view has been the lowering of short-term interest rates since the global financial crisis (GFC), however, this lower for longer position has now shifted to lower still for even longer.

Where to from here?

We are likely to see a period of further sustained low interest rates, with two to three more reductions to below 1% in the short-term. Figure 1 shows various possible paths, but the reality is, generationally low interest rates will continue for several years to come.

Figure 1 - RBA Action to return to 3%

Diagram showing Figure 1 - RBA Action to return to 3%

The RBA catches up with reality

The RBA’s economic forecasting has been woeful over the last eight years (not helped by a budget-constrained Australian Bureau of Statistics). This is now more evident in key measures of household health, a fundamental part of consumption demand (which forms more than 60% of the economy).

We do not believe the unemployment rate is a reliable indicator of economic health. Instead, employment measures – accounting for underemployment and participation rates – look decidedly worse than the headline unemployment figure. This is consistent with poor retail spending, constrained wages growth, below-target inflation and consumer confidence data.

Figure 2 shows the underemployment level as measured by hours worked for the available labour force, indicating underemployment is exceptionally high, with corresponding impacts on low household income growth. Average hours worked per worker has consistently deteriorated not improved over the last 10 years since the GFC. This is completely at odds with the headline unemployment statistics.

Figure 2 - Employment, hours and average hours

Diagram showing Figure 2 - Employment, hours and average hours

Figure 3 shows the level of household debt to income. This is also at a historic high. Households can service this debt due to historically low rates, but therein lies the twofold problem for rate policy setters:

  1. The household debt load has hit a ‘brick wall’, and with it, debt-funded consumption has slowed.
  2. Households cannot bear an increased interest cost without causing significant harm to consumption and financial stability.

Figure 3 - Household debt and house prices

Diagram showing Figure 3 - Household debt and house prices

Low interest rate trap

Australia appears to be heading towards a ‘low interest rate trap’ – as has happened in other developed markets – where low rates lead to stagnating economic growth and weak wage growth. This ultimately drives further rate cuts in the medium term. Should we face a severe economic shock, the interest rate lever, having already been fully pulled and utilised, will leave Australia with some awkward, unchartered and unorthodox monetary options.

The most concerning elements of this trap are:

  1. The encouragement of more debt build-up in existing assets (i.e. housing and equities).
  2. The suppression of interest income from savings, leading to increased risk-taking behaviour as investors ‘search for yield’.

Should a downturn happen, these elements will increase financial instability and magnify its impact.

Low interest rate trap

Diagram showing Low interest rate trap

Investment implications

Base rate yields will fall over the next two years (as risk margins already have), forcing investors to reconsider their portfolio balances.

Our approach is to diversify the source of investment income by rebalancing the weight to floating securities with shorter maturities and selective corporate bonds with medium-term maturities. Examples include:

  • Selective United States Dollar (USD) bonds where yields have risen over the past two years
  • Corporate fixed bonds that benefit from capital appreciation as interest rates fall
  • Well-seasoned residential mortgage-backed securities (RMBS) securities that maintain significant equity buffers.

Investors must critically examine changes to risk appetite and preference against the real economic landscape before altering risk profiles. Importantly, investors must remain watchful to the low rates trap and the risk of ‘chasing the yield tail’ at the cost of capital security and sustainable returns.

For more information on our approach to investment management or any other enquiries, please contact us at +613 9655 5000.