What if...:

Annette Sampson

YOU’VE GOT TO BE KIDDING!

Yes, it does seem unlikely. But respected economist and former Reserve Bank board member John Edwards put the cat among the pigeons by suggesting it was possible recently. He didn’t set out to scare people deliberately. But it drew attention to the fact that at some stage interest rates have to go up.

THE RATIONALE

For starters, the international trend is up. The US Federal Reserve has already started to lift rates and there have been indications of likely future rate rises in Canada, England and New Zealand, eventually extending into negative interest rate areas such as Europe and Japan.

Rates have been historically low since the GFC when rates were cut to try to stabilise world economies and encourage growth. But that was 10 years ago and, as Edwards pointed out, global growth has been picking up, putting upward pressure on the underlying inflation rate in major economies.

At some stage, rates will have to move back to more normal levels. In Australia, Edwards says the average rate set by the Reserve Bank has been 5.2% over the past 20 years – more than three times the current rate of 1.5%. Even in the aftermath of the GFC, the lowest it got to was 3%.

“It is certainly possible that the ‘natural’ or equilibrium rate may in the future prove to be markedly lower than in the past,” he says. “Even so, even if the RBA thinks a longterm rate may in the future be, say, 3.5%, it is still quite a long way from today’s rate.”

WHAT MIGHT HAPPEN

A survey of experts by comparison website Finder in July found 88% of experts predict the next move will be upwards. But there is no agreement on when or by how much.

Shane Oliver, head of investment strategy for AMP Capital Investors, says that soft consumer spending, slower housing investment, high levels of underemployment and record low wages growth are likely to prevent a rate hike in Australia for a year or more. However, HSBC expects a rise early in 2018 on the back of stronger economic growth and a predicted rise in wages growth in the latter part of this year.

One thing the economists agree on is that, with inflation still low, any move in rates is likely to be gradual as opposed to some of the more drastic rate hikes of the past.

As Edwards points out, household debt is high and the impact of a quarter percentage point rise will be much greater than it was when debt levels were lower. If the Reserve Bank moves too far, too fast, a rate hike could cut consumer spending risking damage to the economy. Edwards says it is also possible our economy has become

used to lower rates and businesses require lower funding costs to invest.

BORROWERS

Under Edwards’s scenario, home loan borrowers could see their mortgage rate rising to around 7% by 2020 while the small business overdraft rate could be closer to 10%. On a $300,000 mortgage, a rise from 5% to 7% would see monthly repayments rise by almost $370 from $1754 to $2120. On a larger mortgage, say $500,000, payments would increase from $2923 to $3534.

Finder statistics show the standard variable rate has already started to rise from around 4.8% in March to just over 5% in July. Investors, particularly those on

interest-only loans, have also been hit with higher rates over the past year.

Of course, some borrowers are better prepared for a rate lift than others. In its Financial Stability Review earlier this year, the Reserve Bank found borrowers in aggregate had around 2½ years’ worth of mortgage repayments in offset accounts and redraw facilities, providing a substantial buffer against rate rises. However, one in three borrowers had no buffer or were less than one month ahead in their repayments.

INVESTORS

If there’s one group likely to be dancing in the streets at the prospect of an interest rate rise, it is self-funded retirees and other savers who have been struggling with low returns in the low-interest-rate era. Many of these investors have been forced into higher-risk investments to generate the returns they need. While the 10-year government bond rate spiked last month in response to talk of higher global rates (it was around 2.7% in mid-July), retail deposit rates have remained steady. Historically, banks have also been slower to pass on rate rises to savers than to borrowers. However, if rates were to rise by 2% by 2020, savers could also expect a higher return on their investments.

Of course, rising rates aren’t good news for all investors. Higher interest rates can have a negative impact on shares because they increase funding costs for companies and make shares less attractive compared to safer investments like bonds. But Oliver says that while shares remain vulnerable to a short-term correction, a bear market is unlikely as rate rises both here and overseas will be gradual and depend on further economic growth. But he says investments that benefited from the search for yield, such as global real estate trusts and listed infrastructure, may be less attractive as bond yields rise.