Change tack as term deposits fall
Term deposit investors have had it pretty good lately, but the clock is ticking and that’s soon to change.
Interest rates will soon be headed lower, and investors sitting comfortably on the sidelines should prepare for that.
If they take too long, they’ll not only miss opportunities elsewhere but they’ll also be facing a hefty fall in income.
With interest rates at the highest level in 15 years, it’s become much easier to earn a steady, reliable income from your savings.
A six-month term deposit is offering a yield of 6 per cent today, so an investor lucky enough to have a $250,000 nest egg can generate a monthly income of $1250 before tax.
However, term deposit rates tend to follow the Official Cash Rate (OCR) closely, which means they’re on borrowed time.
At 5.50 per cent, the OCR is at its highest since 2008. The next move will be down, with the only question being when that first cut comes.
That’ll be a function of how the economy develops and how quickly inflation slows from here.
At 4.7 per cent, the annual inflation rate is still well above the Reserve Bank’s target band of 1-3 per cent.
However, it doesn’t need to wait until it’s within that range before cutting.
The Reserve Bank’s remit is to keep inflation between 1 and 3 per cent over the medium term, which typically means between 18 months and three years.
When it is confident activity is slowing and inflation is headed toward 2 per cent within a year or two, that’ll be the green light for OCR cuts.
Financial markets have become increasingly confident we’ll see the first cut in August, which is less than five months away, and that it’ll keep falling from there.
The upshot is that anyone sitting comfortably in term deposits is facing a declining income stream in the months ahead.
In the past three years, the six-month term deposit rate has been, on average, half a per cent above the OCR.
If market forecasts for the OCR are correct, the term deposit rate will be closer to 5 per cent within 12 months and approaching 4 per cent a year after that.
That equates to a 13 per cent fall in term deposit income looking out one year, and a 30 per cent decline within two to three years.
Short-term deposits are offering great value right now, but don’t get content. Within five months interest rates could already be falling, and after the first cut they’re likely to keep falling.
If that happens, investors will be facing much less attractive reinvestment rates and a declining income stream.
Rather than waiting for the herd to catch on, savvy investors should take advantage of this opportunity and make hay while the sun is still shining.
The changing dynamic will reverberate across other asset classes too, which means there’s a window to take action early.
Right now, investors can lock in attractive yields from high-quality fixed income securities with maturities that stretch out years, rather than months.
The local sharemarket, out of favour in recent years against a backdrop of high interest rates, might also begin to attract more attention from investors.
It might be time to ditch the deposits and get some of that capital working a bit harder.