Yesterday's decision by the RBA to cut interest rates to an all-time low of 1.5% may not have been that surprising but it has raised some questions about how effective any further rate cuts from here would be in stimulating the economy.
The market's negative reaction yesterday certainly suggests investors are not convinced that super-low rates are going to be as beneficial as first thought.
There are a number of reasons why this is the case including:
- Lower income for retirees – As the proportion of our population grows older, the impact of lower interest rates becomes less effective as it negatively impacts the purchasing power of savers like retirees. They earn a lower return on their savings in term deposits and this means they have less money to spend in the economy. This obviously won't help retail companies like Woolworths Limited (ASX: WOW) and Wesfarmers Ltd (ASX: WES).
- Bank margins come under pressure – As interest rates fall, the net interest margins of the banks also falls. This is because of the narrowing spread between what a bank offers its deposit holders and what it can lend out to borrowers. This has been a major issue impacting the earnings of overseas banks and will become a bigger issue for our domestic banks. Only yesterday, the Commonwealth Bank of Australia (ASX: CBA) decided not to pass on the entire rate cut to borrowers in a bid to maintain its own margins.
- The RBA is using all of its ammunition prematurely – Australia's economy is still expanding and travelling quite well compared to most developed economies, yet our interest rates are at record lows. If the RBA keeps cutting rates in this environment, some people are worried that the RBA will be left with no ammunition if a real economic crisis was to hit Australia. This is a legitimate concern and there are arguments to suggest any further cuts from here are unlikely to have a big impact on the economy anyway.
- Lower interest rates fuel asset price bubbles – There is no doubt that lower interest rates have helped to fuel the massive price increases in the residential property markets in Sydney and Melbourne over the past few years. Borrowers, especially investors, have taken advantage of lower interest rates and have been willing to take on higher levels of debt to purchase assets. This is fine while interest rates remain low, but issues may arise when interest rates begin to rise.
- Young borrowers are being left with less discretionary income – In a bid to purchase their first home, an increasing proportion of new home buyers are having to take on record high levels of debt to enter the market. While some of the costs of these massive loans are being offset by lower interest rates, they are nevertheless facing repayments that leave them with less money to spend in the wider economy.
Foolish takeaway
Although lower interest rates generally give the economy and asset prices a nice boost, there will come a point where lower rates just won't have the same beneficial impact.
Australian investors, who generally have a big exposure to banks, should certainly take this into account when considering the make up of their portfolios.
