I wrote a post just last month that laid out the reasons why the banks would probably not be dropping rates independently of the RBA, even though the current funding climate could allow them to do so. Indeed current interest rates are comparable to when we were in the depths of the Global Financial Crisis however our, and the vast majority of others worldwide, economy is no longer struggling. These are things you don’t usually see going hand in hand because when times are good people like to borrow and spend which usually leads to a healthy credit market. It seems that punters are still wary of another GFC-esque situation as whilst the economy has vastly improve the desire for credit hasn’t which is quite odd, but nothing to be concerned about in the grand scheme of things (unless you’re a lender, of course).
It was for those reasons that many did not expect a rate cut from the Reserve Bank yesterday as all the pressures that prompted past cuts (decline in demand for Australian products, Eurozone Crisis, etc.) have run their course. It came as something of a shock then that they decided to cut another 25 basis points off the current cast rate bringing it to a record low 2.75%, dipping below even the lowest rate available during the height of the GFC. The rate decision release makes for some interesting reading as the reasons behind the decision aren’t the ones I was expecting.
The RBA acknowledges that the funding climate has improved dramatically with many of our larger trading partners undergoing periods of expansion. The Eurozone is still in recession although its effect on us is muted, largely thanks to the limited amount of trade with do with them. They also expect investment in the resources sector to reach its peak this year and so part of this rate cut could be a proactive move to encourage people to start investing in other areas before the resources boom starts to tail off. Inflation has remained within their target range being at 2.5% for the past year. However the major factor in cutting rates seems to come from the desire to encourage more spending and moving their savings into more productive asset classes.
It’s true that rate cuts take a while to work their way through the economy and the last year or so of cuts is still having an effect. Primarily this is due to relieving mortgage pressure which doesn’t yield benefits quickly but sustained periods of low rates will eventually lead to more consumer spending (as the RBA notes). This rate cut then appears to be more of a shock tactic rather than a long play, hoping to encourage people to either spend more or entice people into taking out mortgages at rates that will likely not be repeated for quite some time, boosting the credit industry. Additionally rate cuts always put a downward pressure on the Australian dollar which will help boost exports.
The ideas are sound as historically moving the cash rate downward does all the things that they’re expecting this current rate cut to do. However I’m a little sceptical as to whether it will have the desired effect this time around due to the circumstances we find ourselves in. The numerous cuts over the past 18 months, which were largely in reaction to the deteriorating conditions in the Eurozone, haven’t had the large impacts that they did during the GFC. Primarily this is because of how well insulated we are from said crisis but it also appears that Australian’s have lost their appetite for credit. Whilst its easy to lay the blame at the GFC for this I can’t help but feel there’s something else at play here, something which moving the cash rate won’t do much to alleviate.
This whole situation is a result of the weird financial climate we find ourselves in currently. Whilst I might not think the RBA is on the right track with this decision I don’t have any good solutions to the issues at hand because, as far as I can tell, what we have is a crisis of consumer sentiment, not a problem with the funding environment. It’s quite possible that this last dip will be the hair trigger for a major ramp up but I’ll remain sceptical for now as the previous cuts failed to bring that same idea to fruition, even if they were done for different reasons.
The finance market in Australia is in a weird state at the moment. On the one hand we’re doing pretty good economically, with unemployment remaining low and our major trading partners still buying things from us despite our strong dollar. The finance market, specifically credit and lending, on the other hand looks much like it did back during the peak of the global financial crisis with lending rates at record lows. Now it’s not like this is completely unexpected considering that the Eurozone Crisis is still working itself out but favourable economic conditions and low lending rates rarely go hand in hand.
Indeed it’s gotten to the point where the Reserve Bank of Australia doesn’t believe they can effect much more change by lowering the official rate and will likely hold off on any changes until sometime next year. At the same time though banks funding conditions have continued to improve which has led to calls from industry bodies for them to start cutting their rates independent of the RBA. Banks have never been shy to raise rates outside of official RBA decisions but cutting them be something new for all of the major lenders, especially considering the rather turmutuous funding environment we’ve had to endure over the past 5 years.
Now no one would be expecting these cuts to happen now as there’s really no pressure on the market from either direction that would make such a move advantageous. Most industry analysts agree that within the next year however though conditions would be favourable for banks to do this. If this is the case then there’s a pretty simple method for checking to see if banks think that there’ll be a rate cut, whether by them/their competition or the RBA, within the next year. All we have to do is check the current fixed term rates and compare them with the current variable rates on offer and see what the difference is between the various fixed term lengths.
Right now the cheapest variable loan you can secure is about 4.99%, a bargain that we haven’t really seen since the deepest parts of the GFC. Whilst there’s quite a spread between the lowest and highest there’s a pretty good chunk of the market hovering around the 5.25% region so we’ll use that as our baseline for comparison. For a 1 and 2 year fixed loan it’s looking pretty similar with the rates basically remaining the same overall, although there seems to be more lenders willing to lock in at 4.99% for that amount time. It’s only at 3 years do we start to see much change when the average jumps up about 0.25% which is a pretty small increase and is essentially a hedged bet against any unforseen circumstances.
The take away from this is that by and large the banks don’t really expect the funding situation to change dramatically in the next couple years as their loan term loans aren’t really priced with that in mind. There are some examples of lenders offering very attractive rates around the 2 year mark (ones lower than their current variable rates) but they’re most certainly not the majority and consist primarily of smaller, non-bank lenders. Barring any drastic changes (like the Eurozone escalating again) I can’t see any indication that the banks are thinking of moving rates in any meaningful direction for the next couple years, nor do they expect the RBA to do similar.
This doesn’t really mean much unless you’re currently in the market for a new loan or refinancing but if you are then it means that the choice between variable or fixed is essentially moot at this point and you should go with whatever makes you feel the most comfortable. It’s actually a great time to get a home loan thanks to the wide spread stagnation of house prices and cheap funding which are set to continue for at least another year. Of course you probably shouldn’t dive in unless you’ve done the proper due dilligence but if you’ve been on the fence for a while I really can’t think of a better time to buy in the last 5 years.
Well apart from the darkest parts of the GFC, but that had a whole bunch of other issues associated with it.
If you’re a home owner with a variable rate mortgage the past year has been pretty kind to you with the RBA slashing a good 1% off the cash rate, an extraordinary amount of breathing room for many people. It’s also provided some relief for those who dived head first into the property market at the bottom of the Global Financial Crisis, taking advantage of the cheap rates, and over-extended themselves with a loan that was too big for them to handle comfortably. This in turn should be putting an upwards pressure on inflation as people spend more thanks to their incomes being freed up from mortgage payments however it seems that the past year of cuts wasn’t enough and the Reserve Bank of Australia might be lining up to cut rates yet again.
Futures markets have been pricing in a rate cut with a likelihood of 85% which means they’re almost certain that the RBA will cut rates in November. There are several plausible reasons for this like the government returning the budget to surplus and inflation coming in below the RBA’s target however some of the other reasons cited have me a little confused. Weaker currency prices aren’t fixed by rate cuts, they will actually make the currency comparatively cheaper, and citing them as a reason to cut rates would be counter-intuitive. I might be misinterpreting what the article means however as the currency trading rates are only casually mentioned.
The reason why this rate cut and not the ones preceding it have got my attention is the fact that with 1 more 25 basis point cut to the official cash rate we will officially be equal to the rates we saw back when the GFC was in full effect. Now we’re not exactly in the best of times at the moment with the Eurozone Crisis still playing out however we’re not in the midst of a global recession either with most developed countries, including the instigator of the last crisis, having several quarters of positive growth under their belt. The unemployment rate, whilst still being far above its pre-GFC minimum, has remained fairly steady in the 5% range over the past year as well which makes it even more confusing as to why the RBA would look to cut rates at this time.
Looking at their decision for this month where they cut 25 basis points off the rate it’s clear that they’re taking a pretty long term view and I’m not sure what’s changed in the weeks since then that could lead them to believe that they needed to drop rates to a record equalling low. The softer global economic outlook, lower commodity prices and low inflation are all valid reasons to drop the rate however they really haven’t changed in the past month and if another drop is warranted so soon after the previous one it could have easily been rolled into it, giving a single cut of 50 basis points. The RBA is usually reluctant to do rate cuts of that magnitude however (last time it happened was at the start of this year and prior to that it was the massive cuts due to the GFC) but the flip side of that is that the markets usually react better to larger cuts. I’m no economist though so there might be some deeper strategy to this that I’m just not seeing.
Considering the relative economic positions between the peak of the GFC and now it just seems odd that we need to have the cash rate at the same level. The global economy not hurting anywhere near as bad as it was at the same time all those years ago and whilst there are indicators that suggest a rate cut might be warranted it seems over zealous to drive them down to the same levels as when we were on the verge of recession. I’m most certainly not going to complain however as it only means good things for my current investments but I’m more interested in the underlying factors that might drive such a cut. I guess we’ll have to wait until November 6 to find out as anything up until then is going to be firmly in the realms of speculation.