Why Interest Rates are on Hold for a Long Time

interest rates being held

For much of this year, the picture has been one of an improving Australian economy. Employment growth has been decent, and business surveys have pointed to improving conditions.

The general view has gone from one of another potential interest rate cut, to a question of when the rate rising cycle will start.

But the just-completed reporting season didn’t exactly confirm that view. Overall, earnings growth was lacklustre. But that’s what you should expect in a low growth economy.

The great hope for the strengthening economy thesis is that a stronger jobs market would translate into real wages growth, rising consumer confidence, and therefore higher household spending.

Because household consumption accounts for around 55% of the economy, this thesis is crucial. Without it, you’re not going to see a rising interest rate cycle.

Last week, retail sales data came out for the month of August. Spending slumped by 0.6% (7.2% annualised), which was the worst result in four-and-a-half years. It comes on the back of a 0.2% fall in July.

Even though retail sales represent only about one-third of total household spending, the fact that the August data showed broad based weakness across states and categories is a concern.

The message is this: Even though employment growth has been good, other factors have combined to keep households under pressure. It paints a picture of a pretty fragile economy. Let me explain…

The biggest culprit behind this fragility is debt. Household debt levels are extremely high. As The Australian reports:

The impact of debt is underlined by the International Monetary Fund’s analysis for its forthcoming global economic outlook, showing that rising household debts deliver a short-term boost to economic growth that is followed by a long-term drag.

The IMF’s analysis shows that on average, a 5 percentage point rise in household debt to GDP over a three-year period foreshadows weaker growth in GDP, which would be 1.25 percentage points lower in three years’ time.

Reserve Bank statistics on household balance sheets show that total debts have risen from 123 per cent of GDP to 137 per cent over the past five years, or a 14 percentage point increase.

Clearly, the increase in debt relative to GDP is a drag on economic growth.

That’s because higher debt means more household income is devoted to debt servicing. And due to regulatory tightening, banks have increased rates for various borrowers in recent months, increasing debt servicing costs even without a Reserve Bank rate rise. 

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On top of that, you’ve got rising energy costs (which I’ve discussed recently) digging further into households’ hip pockets.

But it’s not only the recent increases in interest rates and energy having an impact. The overall trend of tepid wages growth and sharply rising inflation in certain areas means households are getting progressively squeezed.

As this analysis from The Australian points out:

In the five years to 2015, average spending on alcohol, tobacco, clothing and furnishings held steady at an average of $146 a week while there was only a 16 per cent rise in spending on food. Spending on housing, utilities, health and household services was all up by more than 25 per cent while education spending was up 43 per cent.

Compare those price rises to how wages have performed over the same timeframe and you get another sense of the squeeze on consumers.

Needless to say, the view on interest rate movements has changed recently. You’re seeing this in the performance of the Aussie dollar. As you can see in the chart below, the local currency reached a high of just over 81 US cents in September. Last week it finished trading at 78.64 US cents, down nearly 3% from the peak.

Australian Interest Rate 06-09-17
Australian Interest Rate

Source: Optuma
[Click to open new window]

Strangely enough, if this trend continues, it could be good for the stock market. In general, stocks usually like a low currency and the prospect of interest rates being firmly on hold.

As long as the economy isn’t deteriorating too quickly, stocks will be happy with a weaker currency.

The one caveat is how foreign investors will react. A falling currency means foreigners take a loss even if the market stays flat. So in the short term they may exit as the currency falls.

The bottom line is this: Don’t expect the market to tank, just because the economy appears to be losing momentum. The golden rule of markets is that they always do what you least expect, or what you think is obvious.

The market’s behaviour is only ever obvious in hindsight — when it’s too late to profit from it. Keep this in mind when assessing your outlook over the next few months.

And if you’re a bear, try to avoid the damaging confirmation bias that comes with latching onto the latest round of bad news. It will only blind you to the genuine money making opportunities that are out there.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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