Key reasons why Aussie investors are facing an interest rate dilemma

By Matthew Lemke
– June 2018

Stock Market

What is the dilemma?

Will interest rates rise in Australia any time soon? Cash investors would be helped if the RBA raised rates. Our view is that a rate hike will happen but not for many months and probably into 2019. In fact the longer the delay the more opportunity for other factors to intervene that may mean no rates hikes occur at all. The poor returns offered on cash by banks or on bank accounts or term deposits, cash management trusts create a dilemma for many investors who feel they should sell down their equity or property assets.

What is the state of play for Australian interest rates?

Interest rates in Australia at the wholesale and retail level have barely budged for many months as the RBA anchors the cash rate at the all-time low of 1.5%. The major question is whether the RBA will hike like the US Fed, and whether Australia’s longer term bond yields can track higher after falling below US bond yields.

Australian rates and US rates have traditionally moved together. The leads and lags have, however, become far more pronounced as Australia’s economy has become less influenced by the US following the economic rise of Asia, China in particular. The lags are far more evident now given the GFC, now a decade old, was felt far more in the US than Australia which meant US rates fell far more than Australian rates. In fact, the US official cash rate was held at 0% for 7 years between 2008-2015. What we are now seeing is an “unwinding” of this as the US economy has picked up. The Fed started hiking in 2015, and 10 year government bond yields in the US moved from their all-time low of 1.4% in 2016 to over 3% recently, although have since moved back to 2.75%. US bond yields have been buoyed by Trump’s tax cuts and higher budget deficits/government debt, the uptick in US inflation indicators,

plus the synchronised global growth outlook across the US, Europe, Japan, China and other countries. These effects are having a stronger effect on US rates compared to Australia.

I believe Australian interest rates will eventually move higher to “catch-up” and again exceed US rates, as is “normal” historically and also from a fundamental view considering relative inflation and productive potential and capacity. However, there are several powerful factors at work which might cause US rates to stall or even fall back, or which might mean Australian rates catch up but over a far longer time horizon than anyone expects, perhaps as far out as 2020/21.

What are the key factors at work in Australian interest rates?

The main influences are the performance of the Australian economy, employment, and inflation. Inflation remains below the RBA’s 2-3% “target” inflation band. Wage growth and retail sales are relatively slow. The forward-looking inflation rates derived from current market prices of Australian government bonds show only a marginal move above the 2% lower-end of the RBA band over the next few years. These factors present a dilemma for the RBA in its rates policy formulation especially given its desire to avoid any asset “bubbles” from maintaining the official cash rate at 1.5%. Factors offering some scope for rate hikes include fiscal stimulus proposed by both major political parties in their election promises, and the uptick in some of our major export prices.

Several “wildcards” with potential global market implications could influence Australian interest rates. Markets will be “edgy” while these wildcards remain uncertain:

  • The biggest wildcard relates to whether global asset markets (such as bonds, equities, real estate) can continue to perform well. Many are near all-time highs. The volatility seen after the big moves in global equity markets in February 2018 shows how sensitive markets are, and certainly markets are now far more sensitive to news, especially interest rates. US Fed rate hikes and a higher overall global rates environment do indicate solid economic growth which will help the big asset markets overseas, but rate hikes in the US and other big economies such as Europe (where the European Central Bank has indicated its desire to raise rates later this year) will certainly create headwinds. The same can be said of any move by the RBA to raise rates here.
  • Crude oil is a wildcard having ticked up to a 5-year high, before coming back a little in recent days (Brent now US$75.36) adding to US inflation expectations but fears it will impact consumer spending in Australia, reinforcing the view the RBA will stay on the sidelines.
  • The Italian political turmoil is another wildcard; the equities market is on edge with thoughts this could spill over to a general EU crisis with global implications.
  • The last wildcards with global implications are US-China trade, and US-North Korea relations.
  • Other wildcards will no doubt emerge during the year and we need to be alert to this possibility.

    Benefits of Prime Value Cash Plus Fund

    The current dilemma for many investors is how to place funds in cash and earn a satisfactory return when interest rates are likely to stay low for some time, possibly years. This provides an important role for the Prime Value Cash Plus Fund, and the main reason it was established in 2014. The Fund’s aim is to provide a return higher than the cash rate, with franking credits helping the overall return even more, while giving investors the characteristics of cash. The Fund has achieved its performance aim, earning 5% per annum after fees for the past two years. The Fund’s number one goal is to protect investor capital. The unit price has appreciated in a very gradual, measured way since inception highlighting that we are meeting this capital protection objective. The Fund has been designed to

    provide investors with access to all their money easily and quickly when they want it, typically 24-48 hours. The Fund pays out accrued interest on any redemption (which is not the case for many investors who hold term deposits with banks and want their money back earlier than the stated maturity).

    Should interest rates rise, the Fund’s portfolio of investments is positioned to benefit, as the “interest rate duration” of the portfolio is only 0.4 years, which allows it to adapt and benefit from rate rises quickly.

    The Prime Value Cash Plus Fund is rated in the top spot among 124 cash funds surveyed by the independent research firm, Morningstar, and has been awarded 5-star “overall” and “3 year” ratings by Morningstar see : https://www.morningstar.com.au/Funds/FundReport/40475