How Do Interest Rate Rises Affect Investors?
You hear a lot about interest rates at the beginning of each month when the Reserve Bank of Australia meets to review their official cash rate. So, what is the cash rate, why do you have to care and what can you learn from following the movements of interest rates in Australia? Interest rates affect everything from your job and your home, to your shopping bill and your savings account and following is an explanation of how and why.
Why Do Interest Rates Change?
Interest rates go up and down in response to inflation. So what’s inflation? Inflation is a natural rise in the overall cost of living, and a small rise each year is considered normal. If inflation rises too much, the RBA will raise interest rates to slow spending.
So how does spending affect inflation? When there is too much spending, demand outstrips the supply of goods and services and these goods and services then have an inflated value – they cost more than they are actually worth because suppliers know there is a high demand and they can charge whatever they like. When an economy grows very fast, there is a rise in inflation and as spending exceeds production, the value of the dollar decreases because you need more money to buy the same things.
Economic growth does slow by itself and the demand decreases and the supply can again meet the demand comfortably. When the spending does not slow by itself, the RBA will increase interest rates to slow spending because when your mortgage and credit card repayments cost more, you have less disposable income to spend.
How Do Interest Rates Affect Savings Accounts and Term Deposits?
Depending on the investment and how savvy you or your financial advisor is with regards to inflation and interest rate rises, investors can actually benefit from interest rate rises.
How savings accounts benefit from interest rate rises:
· When the cash rate goes up, the high interest on savings accounts goes up. High interest savings accounts offer flexible savings options by allowing savers to deposit as much or as little as they like into their account and access those funds whenever they like. As a result, savers can benefit from the flexibility of interest rate rises too, because the banks will base the interest of a savings account on their standard variable rate, or on the RBA’s cash rate, so high interest savings account holders can benefit from rate rises.
How savers with a term deposit account can make sure they benefit from rate rises:
· Term deposit investors need to account for inflation from the beginning. Term deposit accounts are opened to secure long term returns, however, term deposits can easily make a negative return if they don’t keep up with inflation. Inflation is the general cost of living and so in three years time, the cost of living is going to be higher, so you’re going to need more money to live in the same way – therefore, your term deposit account needs to grow at a rate which outstrips inflation over the term of your investment.
· Banks factor in interest rates and inflation when calculating term deposit returns. In a world and an economy which is just recovering from a financial crisis, everyone can expect interest rates will continue to rise in the foreseeable future; the banks know this when they calculate the interest rates they offer on their term deposits and that is why an interest rate on a longer term is so high, to make sure the rate of a five year term deposit is in line with what the economy will be doing in five years time.
How Interest Rates Affect the Local Economy
So we know that when interest rates go up, it is to slow demand and reduce the inflation rate, but what other effects does the interest rate have on the local economy outside of consumer spending?
Interest rates and unemployment:
· Finding the cause and effect relationship between unemployment and interest rate rises can be like trying to decide whether it was the chicken, or the egg which came first. However, both unemployment and interest rates (like the chicken and the egg) are part of the same equation; to choose the starting point of rising unemployment, it increases in cases of financial insecurity or a slow economy (like during the Global Financial Crisis), when people are spending less and business need to cut costs, so they cut jobs.
· The economy can also be slow when inflation is slow, and if too many people stop spending, there is no economic growth.
· When the economy is slow, and unemployment rates have gone up, the interest rate will tend to come down in response. The aim is to stimulate spending, and reduce the mortgage stress on those Australians who may have already lost their jobs.
Interest rates and property:
· The effect of rising interest rates on property may be obvious because as interest rates go up, so too do mortgage repayments, making housing less affordable to the masses.
· When property is less affordable, there is less demand for it, and property prices will come down – this is where property investors can often reap the rewards of interest rate rises.
· Interest rate rises can also mean that some home owners can no longer afford to pay the mortgage on the house they already have, and need to sell the house quickly before getting in to more financial trouble. Quick (and often desperate) property sales in times of rising interest rates also means the property prices fall and for long term property investors this is not an issue as the market will eventually even out, but for property investors wanting to cash in their investment in a property downturn, they can make a loss on their investment due to decreases demand.
How Interest Rates Affect Wider Markets and Investments
Interest rates in Australia don’t necessarily affect international export markets or shares, by they can be indicative of movements and trends in these wider markets, and investors should take note.
Interest rates and exports:
· When interest rates rise in Australia it is because the economy is getting stronger, and this includes the dollar becoming stronger – and worth more. As a result, our exports are less competitive with other international markets whose currency may still be weaker.
· Instead, as interest rates in Australia go up, foreign investors want to lend money to Australia and get in on the extra interest they can earn from Australian customers. However, to lend money to Australians, the foreign investors need Australian dollars, this creates more demand and maintains a higher price.
· A higher dollar is also good for imports as a stronger Australian dollar will buy more raw materials such as oil and produce, which can then be charged at a lower price to Australians.
Interest rates and the share market:
· Investors demand high returns from the share market to make their investments worth the extra risk.
· One less risky investment option is a 10 year government bond, which can indicate the movements of the share market.
· A 10 year government bond is a very safe investment of funds, invested with the Federal Government for the next decade, and the interest rate on this investment can indicate where the RBA’s interest rates are headed.
· For example, in January 2009 a 10 year government bond was offering investors less than 4.00% interest. In June 2009 the rate had jumped to 5.80% meaning the government is expecting the official cash rate to increase in a more stable economy.
· Therefore, investments in shares can be expected to offer returns higher than 5.80%, to make up for the risks of the trade.
Investments and interest rates are intrinsically linked and if you know where to look you can find information about where you should be investing and whether cash, shares or property will offer the best return in the future.
Fred Schebesta writes about saving money at Savings Account Finder, he helps people compare and the right savings account to get more interest.