The Good News on Higher Interest Rates
Posted: April 29, 2008
Higher interest rates may be a concern for borrowers, but good news for some investors.
Rising interest rates have been front page news lately, with the emphasis on the pain they cause borrowers. For investors it’s a different story, with higher rates boosting returns on some investments.
The last time interest rates fell was in December 2001, when they dropped to 4.25%. Rates started to rise the following May (2002), and by February 2008 the eleventh rise in a row brought them up to 7%. Quite simply, rates have risen because the Australian economy has grown strongly, creating some imbalances of supply and demand, sparking higher inflation.
Interest rates can be a powerful tool with which to control the economy. When rates rise, borrowers have to pay more in interest. For households with mortgages, this means there is less money to spend on other things, so consumer demand is dampened.
Many companies face a double-whammy. If they carry debt, as most companies do, the higher interest costs eat into their profits. Any reduction in consumer spending may lead to lower sales, further decreasing profitability. As a result, companies reduce their investment in new equipment and buy less from suppliers. This tends to decrease economic activity, thus reducing demand and lowering inflation. The challenge for the Reserve Bank is to make sure it doesn’t push rates too far and choke off growth completely.
But for investors with little or no debt, higher interest rates may be welcomed. Whilst corporate profits and growth in share prices may be dampened, cash and other income earning investments become more attractive. For example, in the last two years the rates available on three month term deposits have risen from 4% to over 7%. Returns on cash management accounts, mortgage trusts and other income earning investments have also risen similarly.
This doesn’t mean investors should jump out of growth assets and into cash. As we discuss later in this newsletter, there may be good buying opportunities in the share market at present. At current prices the fully franked yields on some blue chip shares offer a very attractive income. What it does mean is that the returns from the cash and other stable income earning investments in your portfolio will have a greater positive impact compared to the recent past.
Most economists seem to think interest rates could rise further in coming months. Again, that’s good for some, but not for all. To stem the tide, one option would be to all hold back a little on our discretionary spending. It will make life just a little bit easier for the Reserve Bank, and with the higher interest rates on offer, we’ll reap a greater benefit from our increased savings.