How Will a 1.75% Cash Rate Affect Investors?

The Reserve Bank of Australia (RBA) shocked many analysts when it cut rates on Tuesday. The RBA decided to cut the cash rate by 0.25%, to 1.75%. Their rationale for doing so was to prop up inflation. While some expected the RBA to take a sit and wait approach, last week’s inflation number had put a rate cut on the table.

Australian CPI (inflation) declined to negative 0.2%, from 0.4%, last Wednesday. This took many commentators by surprise, as inflation was expected to decline only 0.1%. In order to maintain Australia’s growth, the RBA sought to take immediate action. RBA Governor Glenn Stevens said in his monetary policy statement:

Inflation has been quite low for some time and recent data were unexpectedly low. While the quarterly data contain some temporary factors, these results, together with ongoing very subdued growth in labour costs and very low cost pressures elsewhere in the world, point to a lower outlook for inflation than previously forecast.

OK, so we all know why the RBA cut rates. They’re aiming to simulate growth across the economy. But interest rates affect more than just inflation, which you are probably well aware of. A change in rates could mean either less or more business spending; it could also affect the Aussie dollar and have a carryon effect in the property market.

The three reasons above are only a few of the many variables that interest rate affect, directly or indirectly. The most recent cut may not be the only one in the near future. The majority of market economists surveyed now believe the RBA will follow up with another cut in August. While this is definitely possible, predicting rate cuts has never been their strong suit.

But past experience does seem to point to another cut. ANZ Banking Group’s [ASX:ANZ] Felicity Emmett said this is unlikely to be a one and done cut. ‘The RBA nearly always follows up with another cut and we expect this time to be no different,’ Ms Emmett said.

Some are even stating that rates might stay this low for the next two years. Paul Dales, from Capital Economics stated, noted: ‘The RBA cut rates not just because underlying inflation has been low, but because the weaker economic outlook and stronger dollar means that it will remain low this year and next.

A rate cut could be warranted if inflation data for the second quarter doesn’t improve. Underlying inflation is currently at 1%. If the first cut doesn’t show signs of improving this figure towards 2–3%, we all may be in for another cut.

RBA Official Cash Rate

Source: ABS; RBA

What does this mean for investors?

How will cutting interest rates affect things like the AUD, property or even stocks? Let’s tackle each of these three one by one, explaining what lower rates mean for each.

The Aussie Dollar

The Australian dollar has concerned many people this year. While it’s hasn’t reached its heyday of US$1.00, it’s still trading slightly above 78 cents. But isn’t a high AUD good? After all, it means we can buy more foreign goods with our money.

This is true of course, but think about it in reverse. With a higher AUD, other countries have to pay more for Australian goods. Therefore, if there’s a cheap substitute available on the market, it’s likely that Australian exports will decrease, as our goods fail to compete against competitors.

All those people clamouring for a lower AUD got what they wanted. The Aussie dollar dropped suddenly as soon as rates were cut. The AUD went from 77.18 cent to 75.56 cents in a matter of minutes. But the dollar continued to trade down, and is now sitting around 74.74 cents, which represents a total percentage drop of 3.16%.

AUD USD Forex

Source: Forex Factory

Why does the Australian currency drop when rates are cut?

If we take a global view, it’s very logical to see why domestic currencies depreciate when rates are cut. If the Australian interest rate drops, it becomes less attractive for foreign investors to invest in. They now are earning less by storing their capital in Australia, and instead look for higher returns elsewhere.

Therefore, if foreign investors decide to take their money out of Australia, they are effectively selling the AUD. This is then coupled with less demand, placing pressure on the Aussie dollar, causing it to fall.

It’s is a very general way of looking at it, but I find keeping things simple is the best approach when looking at the economy. So what does a lower AUD mean? Putting two and two together, Australian exports are likely to increase. Why? With a lower AUD, foreign buyers are able to buy more Australian goods…and maybe even increase their spending.

Property

While a whole report could be dedicated to this subject, I’ll try to keep it brief. The common belief is that when interest rates decrease, property prices increase. This is not a direct relationship; rather, it is indirect through the affordability of mortgages.

When the RBA decreases the cash rate, it’s good news for bank. The cash rate is the rate at which banks lend to each other. So while you and I could borrow at 5–6%, banks are borrowing and lending among themselves at 1.75%.

When the cash rate is lowered, banks can borrow money at a lower interest rate. And because banks are so competitive, they decide to lower their own lending rates. In lowering their fixed and variable rates, banks also reduce repayments homeowners would be making on their mortgages.

So lowering the cash rate actually makes it cheaper to buy a house. And because land (in desired areas) is scarce, a whole troop of buyers come onto the market, inflating prices. Some believe this to already be a problem that Australian first home buyers are facing. The notion is that affordability close to the city just isn’t there. It leaves first time home buyers with little choice but to purchase property out in the sticks.

But while affordability in some areas of Melbourne and Sydney is getting out of hand, you can’t get prime location for nothing. What I’m getting at is that you shouldn’t be able to afford to live in Toorak, or on the Sydney harbour, once you get out of school. Those areas are expensive for a reason.

So while lower interest rates might fuel more buying in the property sphere, what really drives prices is owner-occupier demand. If people want to live somewhere, their emotions will justify the prices they pay.

Stocks

Just like the AUD, Australian share reacted as soon as the rate cut was revealed. But instead of dropping, shares spiked up on the news of the cut. The S&P/ASX 200 climbed almost 2% after rates were cut — why?

SP ASX 200 AXJO

Source: Investing.com

Again, it’s best to keep things simple. Just like you or I would borrow money from the banks, businesses do the same, but on a much larger scale. Therefore, if the interest rate decreases, and the banks lower their own lending rates, interest payments for businesses become cheaper.

A lower interest rate might also encourage more businesses to borrow money to generate higher profits for shareholders. So when the ASX 200 spiked just after rates were cut, it was a sign of a confidence boost from investors. With lower rates, it gives businesses the ability to channel more cash into their investments.

So does this mean we should get into the market right now? Instead of rushing to buy the first company on the exchange, it would a wiser move to research companies in areas you are interested in.

In any case, it’s possible that there will be a continued stream of slow growth before we return to the boom times of the 2000s.

Härje Ronngard,

Junior Analyst, Money Morning

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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.

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