Watch out! Rates set to fall further

Interest rates may drop further than anyone expects, some depositors might lock in rates while they can.

PORTFOLIO POINT: It’s a tough time for depositors as rates move down more notches and look to be heading lower, while borrowers should look at some of the fixed-rate deals on offer.

All the ingredients are now there for a further major fall in interest rates. For those with cash the falls so far have already been a painful experience but life is set to get worse.

This was one of the clear messages from the Swan mini-budget. A second message was that, rightly or wrongly, Treasury is more optimistic than the market about the China recovery.

But the pressures for lower interest rates extend well beyond the mini-budget. A slice of the money sloshing around the world is going to come to Australia and it will lift the dollar and force the Reserve Bank to lower rates much further. Don’t be fooled if there is no rate reduction in November or December. It’s coming. Those lower rates will drag down equity yields by lifting equity values. Of course, companies hit by the high dollar may be forced to make the adjustment via lower dividends.

Leaving aside global events, Treasurer Wayne Swan is dragging more than $5 billion out of large corporates via accelerated tax and will then extend his cash vacuum to small enterprises so that in all there is an $8 billion extraction from corporate Australia.

In addition Swan plans to spend $390 million to extract $2 billion in extra taxes – most of that will come from smaller enterprises who do not have the resources to fight the commissioner in court.

That money will be found by higher borrowings, restraint on hiring and capital works.

In turn, that will make worse the hidden unemployment – which will be coming to the surface in the next 12 months.

The market is now predicting that interest rates will come down sharply by this time next year.

Those with maturing term deposits are feeling the severe shock and their spending will be cut back, which will mean the stimulus that goes with lower rates will be muted.

I had a look at bank term deposits this week and they have moved down more notches. Westpac had been holding its 5% term deposit rate for five years but has now lowered it to 4.8%. Meanwhile, NAB and CBA are offering only 4.6% for five years. The best five-year term deposit deal is Rabo Bank at 5%. Take some if it for your long-term money. In shorter terms, three- and four-year rates are lower again. In the one-year term NAB’s UBank is the stand out, but it has slashed its rates.

As of Thursday afternoon, NAB, via UBank, is offering 4.8% for a one-year term deposit security where Commonwealth offers just 4%. However CBA’s 11 month rate is 4.5% – the same rate as the non Ubank offers for NAB for one year.

But if I am right, when the Ubank one-year deposit matures the rate offered will be lower again. Three months ago I took some UBank one-year stock at 5.35%, but in nine months’ time I will face a much lower rate. In times of falling rates three to five year money is good.

On the market, bank hybrids are available at better rates but their returns are falling with lower rates. As we saw with NAB, the tougher times will cause bad debts to rise but hybrids only have a problem if the banks stop paying dividends which is not likely to happen.

On the other hand the lower rates will underpin and perhaps boost dwelling values, which will help under pin the banks’ dividend outlook.

The risk for the banks is that they will not be able to maintain their high rates of return given that overseas banks are earning much lower rates of return. But, so far, while Wayne Swan makes noises he has not attacked bank profitability.

On the other hand power utilities are clearly in the gun. Their income therefore carries higher risk.

Now let’s shift to the borrowers. The most obvious piece of advice you can give mortgage holders is to stay flexible and enjoys the lower rate experience.

But wait. At the weekend I was selling raffle tickets at the school fete and had a variety of people wanting to interrupt my ticket selling by raising all sorts of subjects.

One was a banker who confided that the current fixed home loan rates look very attractive and appear to assume large interest rates falls.

Those interest rate declines may eventuate but there are always risks that unforeseen events will block the reductions. If they shop around borrowers are able to lock in the lower rates with a three-year fixed loan. Why would the banks do that?

The simple fact is that those who take out vanilla mortgages are always looking for the next deal. When banks lock you in for three years they have a chance to sell you other products including insurance and financial services. They will make much more money out of the mortgage – or at least they think they will. Do your sums and if the offer is very attractive then you are selling your future business without actually transacting that business. However if I am right about lower rates there is no rush.

Meanwhile, in the Swan mini-budget, Treasury expects that China will rebound. If they are right then mining shares are headed for a good time. My China people tell me that they are not anxious to spark off a new rally in commodity prices (but speculators boosted by US and European money printing may boost commodities anyway). Chinese leaders just want to make sure that a China fall is limited and does not cause damage. But this is not an easy area to forecast and Treasury could be right. But if they are wrong there will be a deficit and Australia’s standard of living will fall because we will not be able it afford the current level of government expenditure.