Get interested
You’ve probably seen a lot of press lately about rising interest rates and heard reports about the impact on household budgets. In August this year the Reserve Bank of Australia increased the official cash rate from 5.75% to 6.0%, after a rise from 5.5% in March. But it all happens for a reason…
In Australia, our central bank, the Reserve Bank of Australia, controls the supply of money and determines the official cash rate in order to control inflation and keep prices stable. This promotes economic growth, high levels of employment and improvements in living standards.
How do interest rates affect the economy?
Interest rates are the price we pay for borrowing money and are affected by supply and demand.
Let’s look at the mortgage market for example. When a lot of people are borrowing money to buy houses, banks and credit unions need to have money available to lend. Often, they can get money from people and companies who hold accounts with them. But if the demand for money is higher than the funds they have available, banks and credit unions have to borrow money by issuing bonds. This is more expensive than paying interest to customers so rates go up.
On the other hand, if banks and credit unions have lots of money to lend but the housing market is slow, they may need to reduce the interest rate to compete for loans.
When the Reserve Bank sees early signs of inflationary “overheating” in the economy they deliberately reduce demand by making money more expensive to borrow. This means increasing the official cash rate. Equally, when there are signs of recession, the Reserve Bank encourages spending by reducing the official cash rate. This has a knock-on effect on all interest rates.
Essentially, when interest rates go down, people don’t have to pay as much interest on their borrowings and therefore have more money to spend on other things. This gives the whole economy a major boost.
Raising interest rates puts the breaks on consumer spending and cools the economy. The tricky bit, for the Reserve Bank, is getting the interest rate just right. If rates get too high and consumers suddenly stop spending, we could end up in a recession.
How do interest rates affect my fixed income investment?
When you buy a fixed income security such as a debenture or bond, you agree to lend your money to the issuer of that security for a fixed rate of return (yield) and fixed term. At the end of the term they repay your loan. When interest rates rise, the price of your fixed income security decreases. This is because issuers of the security have to increase the effective interest to remain competitive in the market. To do this they drop the price of the security, making the interest payment (which remains the same) a higher percentage of the price. Of course, this doesn’t matter if you hold it until maturity.
On the other hand, if interest rates drop, the value of your fixed income security increases, as the higher yield you’ve agreed to becomes more attractive than the current yield.
In Australia and the US since September 2005, we have seen the value of fixed interest investments falling due to subsequent interest rate rises. This has affected rolling 12 month returns for these investments, which have also dropped over the past few months.
But the good news for investors is that their distributions can be invested into these higher rates. So the income being produced is generating a higher return, despite the short-term capital depreciation.
Over the longer-term rising interest rates will mean higher returns for fixed interest funds. When the economy slows these funds will also increase in value. This is good for diversification as many other funds fall when the market slows.
Good news for many self-funded retirees
For some people, particularly self-funded retirees, rising interest rates are good news as many banks pass the benefit onto their depositors. While 65% of Australians do not have mortgages, they stand to benefit from increased interest earned on their savings and term deposits.
Getting the right mix of assets to suit your personal needs can be complicated. That’s why your RetireInvest adviser is there to help you.