An Interest Rate Cut and What it Means for Australian banks

I am definitely not a fortune teller. I cannot predict things with 100% accuracy before they happen — no one can. However, there are those who would like you to believe they are, especially when it comes to predicting price movements.

Many times these people will be big institutional traders who put millions, sometimes billions, on any one trade. It’s not that they know what’s going to happen; instead they have more influence to make good on their claims. For example, if I was a trader with enormous amounts of capital, I’m talking in the hundred millions, and I say ANZ Banking Group’s [ASX:ANZ] share price will go up, it’s probably going to happen.

Do you want to know why? It’s because I have the buying power to keep purchasing the stock, which will artificially increase its value. Then, once a small rally is established, I can sell out for a profit.

This situation is not uncommon. Many retailer traders try to ride these price movements created by institutional traders. And what have institutional traders, even sovereign wealth funds, been doing lately?

They’ve been selling banks across the entire global. European banks saw the most aggressive selling falling to double digit percentages in just one day. It’s now becoming harder for banks to create optimism for the future. Banks are subjected to harsher rules and regulations, affecting their future earnings. Now I can’t say this is a bad thing after seeing the global financial meltdown in 2008. Yet it has put banks in a difficult position to create profits and, ultimately, wealth for shareholders.

Today, however, Australian banks are holding their breath. All eyes are on the Reserve Bank of Australia (RBA) and what they’re planning to do with interest rates this month. The cash rate (interest rate at which banks lend money to each other) is 2%, and many expect the RBA to hold.

So what does this mean? A low cash rate symbolises the RBA’s efforts to stimulate the economy. This allows businesses to borrow and invest money at a cost that is relatively cheap. However, it’s not only businesses that benefit from a low cash rate. Australia as a whole will also benefit from it.

Generally, when interest rates are high then that country’s currency will also be high. The opposite is true when interest rates are low. So is a low Australian dollar good then?

Well, it is. A low Australian dollar makes our goods and services more competitive to global rivals. But there’s always a downside to every upside. Once more countries start demanding Australian goods (in turn demanding more AUD), our currency appreciates.

Once it becomes too high, then demand for the AUD lessens, and thus the price drops back down again. Low interest rates might be good for businesses and Australian exports, but they’re not good for Australian banks.

As the cash rate rises, the profitability of the banking sector also rises. This is because the yield on cash and other investments increases — for example, a bank earning more on a short term bill (government bond). Not to mention the increasing revenues from repaying borrowers. Increasing the cash rate give banks the green light to lift their own rates they offer to clients.

This then rolls onto the Australian public. With lower rates the public can more easily borrow money. And what does everyone want? Homes. Australian first home owners are able to borrow large amounts of money to buy their own dream home.

And you better believe they have to borrow big. Lower interest rates create more demand for homes, driving up housing prices. I guess you could call it a ‘low-hate’ relationship. But it’s not the only factor that goes into the price of property.

Some commentators are even calling for a rate cut. They’re specifically worried about the Australian economy. AMP Capital’s Shane Oliver is not the only one with the same opinion when he says:

The Australian economy probably still needs some more help from the RBA in terms of another interest rate cut – both directly in terms of its impact on growth and also indirectly in terms of maintaining downwards pressure on the value of the Australian dollar.

Nomura rate strategist, Andrew Ticehurst, said the RBA will be reluctant to use up some of its remaining ‘ammunition’. ‘The RBA is uncertain that a rate cut could actually achieve a meaningful result and is not yet convinced that the economy requires more policy support’, he said.

We will know the RBA’s decision at 2.30pm AEST today, which will be followed with a statement explaining their decision.

Härje Ronngard,

Junior Analyst, Money Morning

PS: The big four Australian banks have been beaten down by the market recently. The big four are already down 15–20% for the year and it could get a lot worse. They might not be classified as beaten down blue chips but, with enough time, they could become cheap enough to buy.

There are few beaten down blue chips out there. Many big companies are just resorting to their fair value instead of becoming cheaper. But according to Money Morning’s publisher Kris Sayce there are five beaten down blue chips within the market right now. And all of them are a ‘buy’.

In Kris’ report, ‘Five Beaten–Down Aussie Blue Chips to Buy Today’, you’ll find out why these stocks are so cheap. Kris also offers great insight on selling dividend payers and why moving some of your capital into beaten down stocks is a good idea.

To get your free copy, click here.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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