The risks on rates

Summary: Official rates remain on hold, but should borrowers do the same?

Key take-out: there’s a degree of safety in locking in, but be prepared for a potential cut.

One of the hardest things to do in my business is handle a call from a friend who has a decision to make and wants to talk about interest rates and/or the currency.

I don’t seek those conversations but this week a single mum who is a family friend was considering whether she should convert the final year of her fixed rate home loan into a flexible rate loan– pay the penalty but enjoy the lower interest charge.

In fact, she had made up her mind because by locking in the rate some years earlier she had not enjoyed the lower recent interest rates, although her house value had risen. She wanted to know the risk of higher Australian interest rates because if rates rose her potential gains from a flexible loan would be destroyed.

I explained that she had to make up her own mind, but this is a question that people all around the country are asking, so let me share my views with the normal caveats that there are no certainties.

I don’t think there is a great deal of risk that in the next 12 months official interest rates will rise. The Reserve Bank has watched the credit squeeze reduce house prices and if it was to raise interest rates, house prices would drop even further and the damage to the total economy would be multiplied many times.

Accordingly, unless there is a change in the total situation, the Reserve Bank doesn’t have the flexibility to raise interest rates. Interestingly, in the US there is a version of the same story. Like our Reserve Bank the US Federal Reserve was all set to increase interest rates further. Neither central bank understood the inner workings of the economy in the current environment. It was President Trump that told the Federal Reserve of the risks and it changed its policy. Here in Australia I think the media played a big role in the Reserve Bank understanding what was happening.

The US problem is that too many US corporations have borrowed to the hilt, and if interest rates are lifted it will do incredible damage to business and employment. Here in Australia it’s our consumers who are geared to the hilt and any rise in interest rates will devastate consumer demand. This underlines the fact that central banks don’t have the ability to raise interest rates in the current environment.

The US 10-year bond rate is priced on the basis that there will be no further rate rises, and that is also the view of Australian markets. But could the Reserve Bank lower interest rates? In Australia the veteran Westpac economist Bill Evans believes that in the next 18 months there will be at least two interest rate reductions, because the bank lending clamps will cause further falls in house prices which will force the central bank to lower rates.

Economist Callam Pickering says that interest rates can’t rise in Australia because the underutilisation rate of labour is much too high and contributing to soft wage growth and low inflation.

It will take at least two years for that labour underutilisation to be absorbed and that assumes a strong economy. So, my single mum looks safe on the flexible rate, but Pickering does not agree with Evans that rate reductions are a certainty because current employment is too strong.

The bottom line for readers is that in bank term deposits there is a degree of safety in taking somewhat longer terms on bank deposits and other interest-bearing securities. Of course, the longer the term the greater the risk.

And, at least during the next 12 months, borrowers can take the lower flexible interest rate with low risk, although it is always safer to have part of your borrowing portfolio on a fixed rate because events can surprise.

Changes under Labor

To a different subject and regardless of your political views it’s time to factor in an ALP government in May. When the refugee controversy reared its head earlier this month the Fairfax opinion polls showed a swing toward the Coalition.

A few weeks later the Newspoll showed that that swing had evaporated and the ALP was almost certain to be elected. It is very clear that many Australians have had enough of the current government and for the most part are not listening to its arguments. Whilst that might be grossly unfair that is the way it is. That means that readers need to begin to seriously look at their investment and asset situation in the light of the ALP policies.

Labor plans to cut back the amount of money you can invest in superannuation without a tax deduction from $100,000 to $75,000, so if you have the opportunity and you have sufficient cash then invest either $100,000 for one year or the maximum $300,000 (over three years) as a tax paid superannuation contribution.

The ALP plans to increase the capital gains tax. There will be a degree of grandfathering but again you never know what politicians will do, so it is worth considering taking a capital gain before the election. Again, only do that if it makes sense in your total portfolio. With negative gearing many are purchasing houses at present and locking in a negative gearing arrangement, which the ALP has guaranteed to grandfather.

Just remember that once the negative gearing legislation is in place investment buyers of “used” dwellings are going to want positive gearing so that their rental income covers their interest as there will be no tax deduction for interest if it exceeds the dwelling income.

I have discussed many times the franking credit situation, but you at least ought to think about how you will cope with retirement tax. I think there is a possibility that the tax might be rejected in the Senate if the ALP doesn’t get control of both houses, but that is purely a guess, so don’t count on it.

The greatest risk to the interest rate strategy I set out earlier is that the ALP may push wages higher, and with those higher wages will come higher inflation.

In those circumstances there will be sudden pressure to put rates higher, but it will devastate the community. The subject of what the ALP government would mean to investors will be widely discussed and I will have more detailed views on the subject as the election nears and policies are more clearly set out, but start to prepare yourself.