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interest rates

Are subzero interest rates forecast for Australia?

The Market Herald

The Australian economy looks to have avoided a worst-case outcome, but with more than 1.5 million people officially unemployed and many more supported by JobKeeper, the road to recovery will require bold action.

One suggestion has been reducing the RBA cash rate below zero. Notwithstanding the logistical and implementation issues with such a move, we are skeptical of the ability of negative interest rates to support a sustainable economic recovery.

In theory, very low (or negative) interest rates make borrowing more affordable and incentivise savers to increase consumption. Real world evidence suggests, however, that unintended consequences arise when interest rates are flipped into negative territory.

Several European countries have had negative interest rates for some time, with mixed results. Existing borrowers have undoubtedly seen their interest burdens decline, but savers have interpreted the situation more cautiously, evidenced by the continued increase of bank deposits despite the deeply unattractive interest rate. The continued demand for government bonds with negative yields to maturity shows that it is not just retail investors that are grappling with this most unconventional of situations.

Other challenges that have been observed include:

  • Forcing savers that do not wish to increase consumption to consider higher risk assets that increase the possibility of capital volatility or loss.
  • Falling bank incomes as lending becomes less profitable, impacting the ability to pay dividends to shareholders.
  • Artificially inflated asset prices (including residential property), which can create inequality by disproportionately helping asset owners at the expense of other members of society.

While we believe that the Reserve Bank will not implement negative rates, many local investors are already facing the challenges listed above. Furthermore, because Australian households are highly indebted by world standards, the ability to take advantage of cheap borrowing rates is limited.

The key issue for investors remains the preservation of an acceptable income stream while seeking to preserve capital. Just as courageous policy action is required to support the economic recovery, investors need to make bold decisions in the months and years ahead. The success of the reopening strategy, the outlook for inflation and how quickly consumer and business confidence can rebound will all factor strongly in the decision-making process.

One thing is for sure though – a pragmatic and flexible approach to asset allocation will be required to identify quality opportunities that align with post-COVID realities. The typical pre-crisis portfolio overweight equities and cash is already showing vulnerabilities as dividends are being cancelled or deferred and the return on cash-based investments fall.

In conclusion, interest rates are set to remain close to zero for some time yet. While actual negative rates would pose additional issues, the core challenges will remain for as long as rates are artificially suppressed. Investors need to accept this reality and adjust their strategy accordingly.

Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.