Beware the rate cut dampeners

The normal stimulatory effects of any rate cut the Reserve Bank makes today will be softened by the self-managed super fund sector's return to the sharemarket, with our banks caught in a vicious circle.

Self-managed super fund owners have started to take their money out of banks and invest it in the sharemarket, so today’s expected interest rate reduction will not be nearly as stimulatory as it would have been had rates been cut much earlier.

What is happening in our banking system is part of a global pattern of events. There is a similar version of the Australian phenomena taking place elsewhere in the world, which is reducing the stimulation normally created by lower interest rates.

I hope the Reserve Bank has cottoned on to these new developments.

Conventionally when the Reserve Bank lowers interest rates it encourages business to borrow by lowering their interest burden. Housing, which is one of the more sensitive interest rate markets, receives a big boost.

This effect will still operate but its impact will be lessened by the effect on the bank funding base. In the past decade there was unlimited credit available for Australian lending because our banks could borrow whatever they wanted on the overseas wholesale markets at low rates of interest.

In the last two or three years that market has effectively closed down at least twice and has also become very expensive because of the problems in Europe. Accordingly our banks are now seeking to attract more and more local deposits. And so whereas in times gone by, local deposits could be as low as 40 per cent of bank funding, now they are nudging 60 per cent and most Australian banks are looking to take local deposits to 70 to 80 per cent of their loan book.

One of the biggest contributors to bank deposits has been self-managed superannuation funds, with fund owners that have relished the idea of receiving a 6 per cent return (and often much more) with minimal risk. But banks have now lowered their deposit rates to around the 5.5 per cent level and once they did that self-managed fund owners started to look elsewhere. As a result, self-managed funds have been withdrawing from the bank deposit market and investing their money in hybrids or high-yielding shares.

Self-managed fund administrator Multiport (a subsidiary of AMP), has surveyed 1800 funds managing $1.4 billion and found that cash held in the self-managed funds slumped from 27 per cent of portfolios in the December quarter to 22.9 per cent in the March 2012 quarter. Most of that money went to the sharemarket, which includes hybrids.

Let’s assume that interest rates are cut another half a per cent in May-June and that flows into deposit rates. Even more money will flow out of bank deposits into the sharemarket. To replace that money banks could theoretically go back to overseas markets to borrow but that option is no longer on the table. So they will have to curb their lending or bid up for deposits.

As it happens the big fall in business confidence that has been isolated by Dunn and Bradstreet is limiting demand for business lending, particularly in south eastern states and the job insecurity so created will keep a lid on housing demand. But if lower interest rates were to stimulate demand markedly then banks would have to lift their deposit rates to woo back the money which would flow into lending rates.

This vicious circle will curb the stimulatory effect of lower interest rates. And of course outside the super fund movement lower interest rates will curb the spending of people relying on interest-bearing deposits to live.

I must emphasise that Australian interest rates are very high at the moment and they must come down. Just don’t expect a ‘normal’ stimulation. A lower dollar would be much more beneficial.

In a strange way a similar effect is being created by the very low interest rates in the US and Europe. Shareholders now want higher dividend payments and are less interested in companies reinvesting their profits. So that curbs the amount of money available for expansion. Australian miners BHP Billiton and Rio Tinto are both being subjected to this pressure.


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