Interest Rates: Are We There Yet?

The global experience tells us that monetary policy has less effectiveness as rates move towards zero and below.

Every time the RBA has cut rates over the past two years, it has been met with a chorus of commentators claiming that the cut was unnecessary. Then, after a period of time, there is tacit acknowledgement that it was the right decision, and the debate continues whether we need more policy accommodation. With the policy rate now at 1.5%, we are deep into uncharted territory, but that does not mean we have reached our final destination.

The global experience tells us that monetary policy has less effectiveness as rates move towards zero and below, as yield curves flatten and the financial sector struggles to generate profits, but if monetary policy is the only game in town, what choice is there?

The rest of the developed world is well advanced down the monetary policy path, and in some cases, the realisation has set in that monetary policy is not the cure-all and fiscal policy will need to play its role. Australia has the chance to front-load productive fiscal policy now, but the combination of ineffective politics and the threat of losing our AAA rating means fiscal support for our economy is likely heading in the wrong direction.

Headline growth in the Australian economy seems OK, but when you look below the surface, growth in the domestic economy is anaemic, with housing the only sector responding to easier monetary policy.

This “unbalanced rebalancing” can be characterised as moving from a sector where Australia had a legitimate comparative advantage to a sector where it has a comparative disadvantage. The mining sector benefitted from ample sources of high quality ore and proximity to China, whereas the housing sector will likely eventually be weighed down by Australia’s highly levered consumer, rising house prices and virtually no limit on the supply response.

Lower interest rates may indeed exacerbate this imbalance, but there is no magic solution and every policy step has both intended and unintended consequences.

Looking at recent results from the Australian banks, lower rates have not yet impacted bank profitability in a negative way, nor have regulatory changes, so we have not reached the limiting factor that appears to have been reached elsewhere in the world.

As a result, there is likely to be more heavy lifting required from the RBA and, in turn, the already excessively levered consumer.

When it comes to investing in this environment, investors need to play the hand they are dealt. Like the RBA, investors may find that facing up to reality leads to much better decisions. Rather than invest for better days ahead, investors should position their portfolios in line with the fundamental economic backdrop today, the current valuation of assets and very importantly, the policy settings that are most likely to occur ‒ not what they think should occur.

Specifically, investors approaching or in retirement should acknowledge that expected returns will be lower and that chasing higher returns equals taking much higher risk; they should also take advantage of the effective ways to generate relatively capital-stable real income and consider investing in bonds; and they should diversify across asset classes to help reduce portfolio volatility. The negative correlation between bonds and equities was actually more pronounced in the first half of 2016 than at any other time since the Global Financial Crisis, so despite the relatively low level of interest rates, equity-heavy portfolios are less volatile when investors include bonds in the mix.

Lower rates for even longer will be a core part of Australia’s New Normal, so invest accordingly.

The Author

Robert Mead

Co-head of Asia-Pacific Portfolio Management

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PIMCO Australia Pty Ltd
ABN 54 084 280 508
AFS Licence 246862
Level 19, 5 Martin Place
Sydney, NSW 2000

This presentation is not a recommendation to hold, purchase or sell a particular financial product and may not include all the information an investor needs to make an investment decision. Past performance is not a reliable indicator of future results. This communication is intended to provide general information only and has not taken into account the objectives, financial situation or needs of investors. Before making an investment decision investors should obtain professional advice and consider whether the information is appropriate having regard to their objectives, financial situation and needs. Before making an investment decision, investors should consider whether the information herein is appropriate in light of their particular investment needs, objectives and financial circumstances.