How low can interest rates go?

The official cash rate set by the Reserve Bank of Australia (RBA) on the first Tuesday of every month currently sits at 2.5%. This is a quite a distance from the 17.5% cash rate Australia endured in the winter of 1990 and creates an interesting economic and investment back drop for investors and home owners today. Just a few short years ago in 2008, it was possible for Mum and Dad retirees and conservative investors alike to achieve a risk free rate on savings accounts of 7.6% with rates upwards of 8.0% not uncommon. Since then, interest rates have fallen and continue to tumble….. but the question remains…. how low can interest rates go?

Reserve Bank of Australia Cash Rate (1969 to 2014)

A quick look at history and the bigger picture often gives great insight into future economic trends. Mark Twain once said “History doesn’t repeat itself, but it does rhyme” and the long term rhythm of interest rates suggests we should be bottoming out around now, give or take a few years. Long term interest rates tend to move in big 30 year cycles with peaks occurring in the 1920’s, troughs occurring in the 1950’s, peaks in the 1980’s, and now what appears to be a long extended trough into the 2010’s.

AJ Financial Planning’s clients have also asked us recently – how do we know when interest rates are no longer falling so we can plan our term deposit and fixed interest investment strategies and manage our fixed and variable rate home loan strategies?

Two of the major factors influencing the RBA’s decision on the cash rate are inflation and economic strength. The likelihood of Australia defaulting on its debt is also a significant factor, however this has been discounted almost completely at this time as currently Australia holds a S&P AAA credit rating- so the likelihood of default is remote. For the people of Argentina however, this is a very different story and with default risks are running high whereby the drastic affects of this being seen in the interest rate markets of that nation.

In July 2014, Commonwealth Bank released it’s 5 year fixed rate home loan at 4.99% p.a.- with the other major banks of Westpac, NAB & ANZ quick to follow suit. This is significant in answering our questions about the future of rates as it provides great insight into the bank’s views for the next several years. From a statistical perspective, the probability of a borrower being in a better financial position at the end of a fixed rate term compared to staying with a variable rate home loan is typically less than a 15% chance.

This is not to say that fixed rate loans don’t provide a very effective strategy tool, provide great certainty for borrowers and many other benefits. It’s just that Australian banks prefer variable rate loans which carry less risk for the lender because they can be easily adjusted to changing economic conditions, and price fixed rates high enough to incentivise borrowers to take on variable rates.

Your AJ Financial Planning professional adviser is available to answer any of your interest rate questions so you can chart an effective course for your investment strategies- as well as anticipate future trend changes.