Thursday, 5 February 2015

The Interest Rate: Explanations and Predictions

An Economic perspective
On Tuesday the RBA cut the cash rate to 2.25 percent, creating a historic low since they gained independence. Glenn Stevens justified this with “below trend” economic growth and weak domestic demand as these result in a higher unemployment rate. Therefore it is implied that this Friday’s economic update will involve a markdown in economic growth forecasts for 2015 (set at 2.5-3.5 percent). Had the RBA maintained the 2.5 percent cash rate they would certainly fall further short of their forecasted growth as the markdown includes the anticipated macroeconomic expansion. The slower forecasted rate of real economic growth should also imply delayed progress in raising interest rates and closing the output gap.
Although such stimulus does depend on whether the cut is fully passed to consumers and owners of SMEs; despite a downward trend of cash rates since October 2010, credit card rates remain around 20 percent. Furthermore 76 percent of CBA customers are ahead on mortgage repayments, with a record level of ANZ customers paying back more than their minimum amount. This suggests that despite Australians currently holding more disposable income than in the past, they are using it to relieve debt rather than boost consumption. Low petrol prices instead should influence their real incomes and therefore spending levels.  
Interestingly, however, the ASX RBA rate indicator placed a 63 percent chance on a cut of 25 basis points on Tuesday, up from a 16 percent chance last week. The Australian dollar responded with a drop of 1.59 US cents to 76.57 US cents as the Australian dollar became an unattractive investment. This should improve Australia’s export competitiveness and hence prevent the weak terms of trade from reducing income growth albeit slowly. Goldman Sachs predicts that “foreign exchange will be neutral in the first half, but should add 2 per cent to industrial earnings over the second half.” Both Treasurer Joe Hockey and Glenn Stevens still maintain that the exchange rate is overvalued, particularly when key commodity prices are taken into account. The financial markets have therefore conformed to a 100 percent probability of another cut by May with a 44 percent probability it will arrive as soon as March, on the basis of overnight index swaps data from Bloomberg.
On a side note, the RBA seems to have shifted out of its normal territory to influence the currency rather than primarily focus on unemployment and inflation. Glenn Stevens seems to have taken into consideration the actions of his global central bank contemporaries, whom have created programs specifically intending to depress currencies. Furthermore Australia still offers a relatively high yield compared to zero and negative rates elsewhere in other developed nations hence the impact of interest rates is questionable.
However I believe further cuts are unlikely if this cut fuels further risk of a housing price bubble. For instance the ME Bank immediately reduced their flagship mortgage rate to 4.62 percent and the three year fixed home loan rate offered by Greater Building Society is 4.44 percent. Mortgage rates have never been below 5 percent since the 1950s. Coupled with the downswing in petrol prices, this is great news for households (Joe Hockey states the benefit is equivalent to a cash rate reduction of a whole 1 percent). Nonetheless APRA’s role in containing the associated economic risks to house prices is essential to ensure that households do not respond to a housing bubble collapse by reducing consumption levels from declines in wealth.
On the other hand, head of research at CoreLogic RP Data, Tim Lawless, contends the economic boost may be slightly less influential on the housing market than previously experienced. Factors that assist in its moderation involve low consumer confidence, tighter serviceability and lending conditions and minimal rental yields. This fuels speculation that rates will be cut again in March to promote further balanced growth, a reasonable effort to improve domestic demand and shift the Australian dollar to its fundamental value before rates rise in response to the considerable momentum of the global economy in the later quarters of 2015.

An Investing perspective
In response to the rate cut the ASX 200 closed at an almost seven year high of 5707.4, with an increase of 82.1 points, whilst All Ordinaries surged by 79.7 points to 5666.2. Due to these rate cuts and also anticipations for further reductions, I believe the sharemarket offers attractive opportunities to grow one’s income. Traditionally telecommunications, infrastructure, utilities and consumer staples, banks and property groups such as Dexus benefit. The rise in their share prices is compatible with the market wide jump in stocks of high yield as investors, particularly those in their pension stage, seek more attractive yet sustainable yields than those offered by bonds or cash.
However the weak earnings growth outlook limits the options of equities for investors. For instance, although the retail industry typically experiences profit from improved consumer sentiment due to the wealth effect from lessened mortgage debt, given the downward series of rate cuts since October 2010, this recent cut should not create a significantly adequate difference.
Telstra nevertheless noticeably benefited, closing at $6.67 on Tuesday, a 14 year high. I believe this can be attributed to its dominance of the mobile industry, as well as its 4.5% dividend yield. Telstra also announced the day before the rate cut that they were considering a sale of its Trading Post business. Despite having paid $636 million a decade ago for its purchase analysts reckon that Telstra is likely to sell it for less than $10 million. Nonetheless it acts as a signal that Telstra is going to focus all its resources into telecommunications now. These therefore should be factors that determine its performance in the sharemarket although Telstra’s revenues in 2015 are only 10% higher than in 2005, suggesting it actually experiences relatively low growth. Therefore I conclude the most significant driver influencing Telstra investors is its steady dividend yield, seeked by SMSFs particularly.
Bank shares also tend to rise in such situations. For instance, CBA is valued 23 percent higher than its competitors given its forward price-to-earnings ratios (these use forecasted earnings). CBA closed on Tuesday with a peak of $90.40, up 0.8 percent, outperforming the ASX200 by 30 percent. (Despite this their forecasted dividend yield is still 4.6 percent before franking credits this financial year. I believe this can be explained by the pressure on banks to accumulate and hold capital. I will write about factors influencing dividends later on). However one may question the profitability of bank shares, as low interest rates should reduce their profit margins. Such yield is from the bank’s interest earning loans i.e assets being greater than its deposits i.e liabilities due to banks repricing their mortgage rates by less than the reduction in the cash rate. Therefore only when banks cut rates on both loans and deposits by the same amount do their profit margins tighten. In reality, the lower interest rates signal that banks are saving more on interest expense than they lose on interest income. In addition, the banks’ provision for doubtful and bad debts are at a minimum level since two decades ago. Clearly this can be attributed to borrowers’ reduced repayments resulting in fewer bad debts for the banks, which encourages credit growth. The below graph demonstrates this correlation:
Source: CBA, Macquarie Research.
Source: CBA, Macquarie Research
Such an outlook however does conflict with my previous research on expected consumer behaviour; the preference of the majority of consumers is to pay back debt, and tighter lending conditions to housing investors for banks means asset growth may be slower than typically expected with rate cuts. There is also the question of whether the 2.25 percent risk free rate leads to an accurate valuation; ceteris paribus, assets are valued higher with the risk free rate being lower. Overall I doubt the level of gain for the ASX 200 will be maintained into 2016 and therefore this strong rally may even cut into future capitalisation. There should be larger reductions in WACC to continue the rate of growth in investor incomes from lower funding costs for corporations. Nonetheless a high single digit growth figure is still a positive sign for things to come.

Financial Times, Bloomberg Business, Sydney Morning Herald, ABC News

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