Run the Red; Run the Risk – How negative interest rates turn economies on their heads.
If you have a home loan or a term deposit, then it is likely that you also have some level of curiosity around what is going on with interest rates.
Each month, the Reserve Bank of Australia (RBA) meets and sets the interest rate. Currently, it’s set at 2%. If the RBA decides to increase interest rates, it is likely your mortgage will also increase, although on the upside, so will term deposit rates; equally, if the RBA drops interest rates, your mortgage repayments will drop—but so too will interest earned from your term deposits.
Like the RBA, the central reserve banks in other countries use interest rates to stimulate or slow their economies. In simple terms, they drop interest rates to stimulate economic activity when things get too ‘hot’, and they increase interest rates to cool them down. Oftentimes, though, the reaction times are a little too slow, which causes things to go off the rails, resulting in the boom-bust cycle continuing ad nauseum.
Now, consider what would happen here if RBA interest rates became negative. What would be the impact on cash in the bank, lending, and other areas of the economy?
Today, Japan, Sweden, Switzerland, and the Euro zone all have negative interest rates (to varying degrees).
If you placed your money into a bank account in Europe right now, it’s highly likely you would be actually charged interest for putting money in the bank. That’s right—you would not be earning interest; instead, you would be charged a fee for depositing the money! In the long term, of course, this really hurts savers and retirees.
Conversely, in some cases if you have a loan with a bank in Europe, the bank will pay your mortgage for having this debt drawn down. Other loans are simply dished out at a very low interest rate, such as 1–2% p.a. Naturally, this encourages people to take on debt at levels far greater than when interest rates are at normal levels.
You can see that very odd things start to happen in the long-term as this topsy-turvy situation plays out.
Other areas of the economy also become distorted. If there is a trade surplus position like Japan, which means they export more than they import, then negative interest rates could end up pushing the currency up against, say, the US dollar.
On the other hand, if there is a trade deficit, the currency can depreciate—like the British pound did against the US dollar. This all has to do with the need for funding and attracting overseas investment to fund the shortfall. In Australia, if we ever went negative, we would almost certainly suffer a similar fate to the UK.
The hope is that in the long term, these economies will normalise and interest rates will return to a more normal level. However, if the market continues to price in negative interest rates for Japan and Switzerland for at least the next 10 years, this phenomenon might be around longer than we think.
So, if you see some strange things happening abroad, remember it might relate to the negative interest rate environments these countries are currently enduring, and bear in mind that one day, their interest rates will likely normalise.
Please also remember that before embarking on any investment decision, you should always seek professional guidance from a licensed financial planner. Of course, I recommend AJ Financial Planning.
If you have been holding term deposits, you may have noticed that the interest rates have been falling. Some may be a little confused why the interest rates were dropping well before the RBA made the change, and are questioning whether they will continue to fall?
Part of the answer comes back to the source of funds. In the past, local banks had been required to obtain deposits from a retail investor through their bank branch network. This is via a more traditional avenue, whereby a person goes into a bank and deposits funds into a term deposit. The banks have found over the past few years that this can be a particularly expensive source of funds.
Needless to say, since then, the need to tap this retail market has reduced. Quiet simply, the banks just don’t really need those term deposits as much as they did a couple of years ago. The main reasons is they can access the funds cheaper via the overseas market.
An example of this is in the Euro zone, where we have recently seen a french utility bond issue half a billion dollars with a 0% interest rate. Whilst they will need to pay the funds back, it is interest free rather than totally free.
But it is not just European companies which are taping into this market, as we are also seeing large international companies abroad following suit. Berkshire Hathaway is also planning to issue a 3 billion euro bond again at a 0% interest rate – not that they need the cash, but if they are handing it out at 0% interest rate, I guess you can always count on Warren Buffett to put his hand out!
Now you may scratch your head a little and go “why would somebody give their money away at a 0% interest rate?” It would be like today going into a bank and asking them to lock away your money for 0% interest for 12 months. However in some countries this is exactly what is happening with interest rates being so low.
The reality today however, is like the examples above, the local banks here in Australia have also been tapping this market too- thus allowing them access to cheaper lines of cash and allowing them to make larger margins and consequently doing away with the notion of the retail investor going into their branch depositing their funds.
There are several other factors why the interest rates have been dropping too- but that is for another day.
So if you don’t know what to do with the term deposit, it is always important to seek professional guidance, and we would recommend AJ Financial Planning.
In 1976 the RBA (Reserve Bank of Australia) cash rate was around 12.85% and the average home loan back then was around 15.35% to 17% p.a. Today some 38 years on, things are very different with the RBA cash rate at 2.5% and the average home loan is around 5%. Now in the past 10 years or so the RBA cash rate has not been as extreme. In reality they have floated between 7.25% and as low as just 2.5% more recently. The question I often here is “Should I borrow more when the interest rates are lower?” You could buy things like a bigger home or an investment property, or use leverage for a business or an investment portfolio? Another other option could be to focus more on paying down debt when interest rates are very low. You can pay down debt a lot faster as the interest rate is not as high. Today, interest rates are incredibly low based on historical measures. Regularly I see ads for 0% finance on a new car being purchased. Credit card companies are offering interest free periods and to purchase an investment properties (depending on the yield as sometimes there can be variance) can be close to cash flow neutral if the deposit is large enough. Alternatively, it could be a time to think about renovating the home using debt, or buying a bigger house and borrow more as interest rates are so low. It can be a very tempting time to go on a credit binge! So the questions becomes “Should I take advantage of all this cheap credit?” The answer however like most questions in finance, is a little more challenging. In reality sometimes you want to be acting counter cyclical with the approach you take. This idea is more common place with investing which goes something like this….. when everybody is running for the hills and not wanting to buy shares…you should be buying shares (assuming the asset is close to the bottom). When everybody is going crazy for shares and there is a bubble you should be possibly thinking about selling. So how do you apply this idea to the interest rate questions? Well most crashes generally are based on cheap credit, the lead up to the GFC people were using their homes and the equity in their properties as an ATM machine to buy stuff. When the cheap credit stopped and the equity stalled everything, or in simplistic terms, it literally ground to a hault including consumer spending. So the answer to the above question comes back to the 2 following questions you might ask?
What am I doing with the credit and what am I trying to buy? If I apply a counter cyclical methodology I should really be asking myself is everybody running for the hills or jumping in thinking this is too good to be true?
Can I afford this debt if interest rates rise on this debt to 8% or higher? Today a 1% increase in interest rates would put 25% of the mortgaged population in mortgage stress, you want to make sure you are not in this sinking boat.
Like all difficult decisions it is important to do some complex financial modelling to work out which is the best way to go, and this is where we can help! We can put together a blue print path for you, crunch all the numbers, and work out the best way for you to go. So if you would like to seek qualified Financial Planning assistance and we would recommend speaking with our team at AJ Financial Planning.