The Million Dollar Question
I write this month’s missive at 12,000m returning from across the ditch after a series of pretty successful management rights seminars in New Zealand.
Aeroplanes are great places to write these articles as there is bugger all else to do and just how many re-runs of Two and A Half Men can one man watch anyway ? The Kiwis seem keen enough about Aussie management rights and certainly the exchange rate is very tempting having improved dramatically over the past year.
Interest rates still look a bit high in NZ and the question everyone asks is “what’s happening with the Australian domestic economy and interest rates?”.
As you are no doubt aware the Reserve Bank took a few people by surprise (me included) and cut the cash rate by 25 basis points to 2.25 per cent at their last meeting. That’s the first cash rate change in 18 months and takes the benchmark to its lowest point in decades.
We now have news that the unemployment rate has jumped to 6.4 per cent and inflation has slowed further. Clearly the resource sector has continued to slow, resource stocks are down and retail sales look a bit patchy. The talk is that the RBA may well have a further two 25 point cuts in mind that would take the cash rate to 1.75 per cent.
Of course, as I have pointed out in previous articles, a super low central bank benchmark rate is not necessarily a good news signal. The cash rate is used predominantly to control broad economic outcomes and a low rate suggests that the central bank is trying to kick start a stalled or slowing economy.
On the positive side borrowers are the winners and so are tourism operators as the exchange rate falls and inbound international tourists take advantage of the windfall. Domestic travellers who might have gone overseas are also deciding to stay at home as the currency exchange cost of international outbound travel rises.
The million dollar question is “where to from here?”
The banks are already factoring in their expectations on future rate trends in respect of fixed rates. As a result don’t necessarily expect fixed rates to follow exactly the cash rate trend set by the RBA. Having said that some fixed rates are lower than the variable rate and there will be borrowers who will choose the certainty and security of a fixed rate option.
Remember, if you fix a rate your options for paying down principal debt faster than your credit contract are restricted with penalties applying for debt reduction in excess of agreed limits. This is a particular consideration for interest only borrowers who may wish to stay on interest only and pay down debt on a discretionary basis.
My view is that if you fall into this category you are better off staying with a variable rate product. Remember, if you on a variable rate loan with interest only terms most lenders will allow you to make any principal repayments you like and most will also let you redraw those funds although some charge a small fee for the redraw. This sort of structure provides excellent flexibility without the contractual obligations of a P and I loan.
Having said that it’s also worth considering that the tax man may well test any redrawn business or investment loan in terms of what you did with the redrawn funds. If you redraw and spend the money on a non-taxable income producing purchase then, in all likelihood, you have lost the tax deductibility of that portion of your loan. Talk to your accountant before you make any final decision on these sort of strategies.
The other trend I am expecting is a rise in the value of blue chip stocks. If you are a retiree living off interest on your investments then falling interest rates are bad news indeed. As a result I expect a flight of cash out of bank term deposits into shares with reasonable yields. Of course, this trend will drive up equity values and comparative yields will fall. Talk about the self-fulfilling prophecy!
Finally, low interest rates have a habit of driving up property and other asset prices as more and more borrowers enter the market on the back of being able to afford more and more debt. As a finance broker this trend should fill me with happiness. Sadly, I’ve been around long enough to know that overheated markets don’t last forever and inevitably the bubble will burst.
We have already seen this in resource sector dependant towns in both residential housing and motels. My advice is to watch the market and always remember that every economic trend will one day turn. You can make money in any market provided you get your timing right.
Mike Phipps
Mike Phipps Finance
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