The low rates realities

The future reality of lower rates for investors

Prior to the Reserve Bank of Australia’s minutes this week, a consensus was building that the RBA may be done with cutting rates.

Investors learned from those minutes that this probably won’t be the reality and, as it stands now, debt futures price in at least one more cut to 2.25% by the end of this year.

Some economists are talking of at least two more cuts and possibly more, from now and into 2014. Now my own view is that the RBA is targeting the exchange rate ,and so future cuts depend on that. Noting this, it’s safe to assume that we will get more, barring an $A that stays around 80-85 cents (which has become the de-facto target). This is likely, because the RBA itself notes that the $A is still too high. Even if I’m wrong, there are those who argue that rates will need to go lower, much lower, because interest rates don’t really seem to be doing much at current levels. Either way then, it’s a good bet that rates will head lower.

Now I know there’s a lot of downcast eyes at the moment in business – “interest rate cuts aren’t working” we heard this week again, and there still doesn’t seem much to be cheery about for investors. As I’ve argued before, I’m not concerned about that as a lasting problem – a structural one or something investors should worry about over the medium term. It truly is only a matter of timing and you only need to see the impact lower rates had – are still having – in the US to see why this must be true. Are we so different? Well we are, because we didn’t have a massive over-investment in housing. We didn’t have a whole bunch of sub-prime loans to offload and we didn’t have massively undercapitalised banks as a result. The US had all that and more, and yet asset prices have rebounded sharply. House prices and equities are surging! So as we approach our own generational interest rate lows – it’s worthwhile thinking about what kind of investment environment we are in.

Property investment is a no brainer

A zero interest rate environment, that’s what! It literally costs nothing to borrow;, maybe not on a cash flow basis, as you still have to have the income to pay what’s due. But certainly real rates are already at zero.

Click to enlarge

More importantly, it’s the same for mortgage rates. And this is critical – because house price inflation creates its own momentum – especially when those rates of inflation are above your borrowing costs like they are now. Take Sydney – annual house price growth of 7% or so with lending rates around 5% or below. Three-year fixed rates are around 4.9%. It’s the same for Darwin and Perth – with Brisbane and Melbourne not too far behind. With limited stock and not much in the way of housing being built, it’s as close as you get to a one-way bet.

Now I know how that sounds. One-way bet. That instantly gets the alarm bells ringing for most and I can appreciate that I might sound a little like a greasy snake oil salesman with a comment like that. But that’s how I genuinely see things, and I’ve got skin in the game having recently bought another property myself.

It comes down to the fact that monetary policy works. Many, many economists, at the RBA even, argue that things will be different this time. I don’t doubt that, but not in the way that people expect. People think it will be different because house prices are already expensive – they are – and because households are already heavily indebted. The last one is less true as two-thirds of households have no debt, and of the one-third that do, most are well ahead in repayments.

What people miss in all of this is that it is not the absolute level of debt that matters anyway. This seems to wrong-foot people all the time. It led people astray during the European debt crisis, through the GFC and even now. The fact is, it’s debt servicing that is the critical variable, and at around 9% of disposable income it’s now the lowest it has been in about a decade (ex the GFC) – that’s the reality of a low interest rate environment for investors.

Click to enlarge

Maybe house prices are overvalued – maybe they are not. Maybe household do have high debt – maybe they don’t. The only question that matters is whether both can push higher. And with interest rates at generational lows, the answer is yes – and that’s exactly what the US experience is teaching us.

Noting this, it’s always wise to think of the risks, and Scott Francis wrote on Monday about the Five risks to a low interest rate environment. It was a good contribution to the discussion and investors are always wise to think about the dangers and the risks. In ordinary times I would probably agree to some extent with Scott. Having said that, we are far from ordinary times.

We are living through a major paradigm shift

The truth is we have witnessed, or are witnessing, a paradigm shift in how economic policy is being conducted. In the model to which we have become accustomed, banks would lend as much money as they wanted, or as much as consumers demanded. The only concern of policymakers was that inflation didn’t get out of control, because inflation as we know distorts market signals and makes it difficult for businesses to plan and price – and for capital to be allocated efficiently. Or, in other words, inflation hides distortions and exacerbates economic volatility.

By design this is changing. The GFC crisis response saw vast swathes of private sector debt, largely held by banks, transferred to public sector balance sheets – governments and their central banks. There is no policy imperative to see government bond yields rise, and thus the interest bill on this debt rise, so central banks are under instruction to keep rates low. There is also a desire to prevent a repeat of 2008, and regulators are taking action.

The problem, of course, is that low rates encourage people to borrow; well that’s not so much the problem, but there’s borrowing and there’s borrowing. Record low interest rates probably encourage people to borrow more than they otherwise would which, as the GFC taught us, doesn’t end well. Already we are seeing rapid house price growth in the UK, Canada, NZ , the US and now perhaps Australia.

We shouldn’t expect the traditional monetary response to this though – governments around the globe cannot afford it and policy line is that the recovery is too fragile to handle it. More to the point, and as the Reserve Bank of New Zealand demonstrated this week, we’re not going to see the traditional rate response. New Zealand has had a house price problem for some years now – a boom, especially in Auckland as a result of record low interest rates. Now instead of raising the official cash rate, which is what we’d normally see, the RBNZ opted to take the regulatory route. Possibly the first of many steps. Specifically, it placed limits on high-loan to value ratio mortgages. Following the decision, banks must now restrict the number of loans that have an LVR over 80%, to 10% of the value of their new home lending. This isn’t a new response and nor is it ground-breaking. The IMF and Bank for International settlements, among others, have been advocating greater ‘macro prudential controls’ as it is called, as an alternative to raising interest rates. Effectively more regulation. With the RBA’s focus on the currency wars, and its established exchange rate target, it is highly likely that the RBA will follow a similar path. Anything so that it doesn’t have to hike rates.

It seems then that our future reality is not going to be too dissimilar to the US, or even the UK. Not just lower rates, but lower rates for longer. House prices are surging, as are stocks – and not a rate hike to be seen anywhere. The Fed can’t even decide on slowing down the printing presses! Against that backdrop I would not get caught up in the economic discussion here – it’s largely detached from reality and to believe it, people have to nominate some reason why we are different from the US, UK, NZ and Canada. Not something I’ve actually seen.