The Great Interest Rate Conundrum

With the RBA taking its regular break from its monthly board meeting in January, we’ll all have to wait until February to find out where interest rates are heading to next.

Having cut rates three times over the last six months or so, the RBA is still in easing mode, with the next move still expected to be down.

However, given the renewed momentum in global equity prices — not to mention a property recovery starting to gain traction locally — you might expect interest rates to be heading the other way.

It certainly has former Federal Treasurer, Peter Costello perplexed. With an unemployment rate of 5.3%, inflation not too far below the RBA’s target band and the current account in surplus, it’s not too hard to fathom his thinking.

Mr Costello was reported as saying that with those kind of numbers, interest rates would have typically come with interest rates of 5–6% in his day.

Yet here we with the cash rate at just 0.75%. How low can they go? RBA Governor Philip Lowe hasn’t ruled out cutting again to stimulate the economy.

And while it might not be on the immediate horizon, neither has he ruled out some form of Quantitative Easing (QE) in the future.

Once the benefits of monetary policy becomes exhausted — as they have now — central bankers are stuck with just one remaining tool…QE.

Under QE, central banks buy assets from the banks, typically government bonds, leaving the banks holding cash. The idea being that banks will need to deploy this cash (lend) to generate some kind of return.

With extra liquidity in the system (that is, more available cash), businesses should take on new projects and investments thereby stimulating the economy and creating more jobs.

Because few had heard of QE prior to the GFC, you might think it a relatively new strategy…a desperate strategy designed for the times.

Yet central banks used it all the way back in the 1920s as the Great Depression ravaged economies all over the globe.

Should rates go higher or lower next?

So who is right? Should rates be much higher, or should the next move again be down?

A big part of the answer to that is in how big a role you believe currency plays in the economy. For an exporter of natural resources like Australia, such as iron ore, coal and gas, a lower currency should be a benefit.

A lower Aussie dollar makes it cheaper for someone with a stronger currency to buy those commodities, thereby pushing up demand…again leading to more jobs.

However, because most central banks are playing the same game, it’s a strategy that may no longer work. The problem for central bankers is that they’re all roped into the same strategy whether they want to or not.

Another factor is the economy and the markets addiction to low rates. Having abandoned its tightening cycle in the US earlier this year, the Fed did a U-turn and has cut the cash rate three times since August.

The Fed will be hesitant to start raising the cash rate again, especially with the US economy still proving to be lackluster. While recent signals might show momentum building again, it is really too early to tell.

Not to mention a president who has an election to fight in 2020. The last thing he wants are for rates to go up and for the wheels to fall off the economy.

For investors here and abroad, it means they are stuck with low interest rates for as long as they care to look into the future.

That means those relying on their savings and investments may have to invest more funds into higher yielding shares, at a time when they would more than likely be putting those same funds into term deposits.

But as the former federal treasurer mentioned, these really are ‘abnormal’ times.

All the best,

Matt Hibbard,

The Rum Rebellion

PS: If generating income is important to you, I have prepared a special report for you, my top five dividend stocks for 2020. You can access it by clicking here.

Matt Hibbard is The Rum Rebellion’s income specialist. With nearly three decades in the markets, Matt has traded just about every asset class there is. The one thing that has stuck with him over this time is a very simple premise. That is, it’s the cash a company generates that ultimately determines its value. Sure, some stocks might fly away to multi-digit gains. But unless these companies can convert the ‘story’ into real money, the market will eventually find them out. And when that happens, the share price quickly falls back to Earth. Matt is also the editor of Options Trader, where he shows subscribers how to use basic options strategies to generate income. This is income they can generate on top of regular dividend payments. Matt doesn’t play the prediction game, where the aim is to be proven ‘right’. Instead, his goal is to generate as much income as he can for his subscribers, irrespective of whether the market is going up or down.

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