While the RBA has cut the official cash rate to within 0.25% of its GFC low, because of bank funding issues lending rates are still well above their 2009 lows.
Basically banks have been seeking to reduce their reliance on non-deposit funding which has proved unreliable since the GFC and to do this they have had to offer higher deposit rates relative to the cash rate than would normally be the case. This has resulted in higher lending rates relative to the cash rate than was the case pre-GFC. Banks have done well to raise the proportion of their funding they get from deposits to 53% from around 40% pre-GFC, but they still lag behind banks in other major countries and tougher capital requirements mean they are under pressure to do more.
The standard variable mortgage rate at around 6.6%, assuming banks pass on around 0.2% of the RBA’s latest 0.25% rate cut, is below its long-term average of 7.25%. But normally rates need to fall well below their long-term average to be confident of stronger growth. And in an environment of household and business caution post-GFC the neutral rate has likely fallen, probably to around 6.75%, which is shown as the “new neutral” level in the next chart. This would suggest that current mortgage rate levels are only just starting to become stimulatory.
In the last two easing cycles the mortgage rate had to fall to around 6.05% in 2002 and to 5.8% in 2009. Given the fall in the likely neutral level for mortgage rates and the current headwinds coming in the form of the strong Aussie dollar and fiscal tightening, mortgage rates will at least need to fall to these lows. Given the ongoing issues with bank funding, to achieve a circa 6% mortgage rate the cash rate will need to fall to around 2.5%.
Chart assumes average large bank standard variable mortgage rates fall to 6.6% following latest RBA rate cut. Source: RBA, AMP Capital
Our assessment is that the RBA is coming around to this view. As such we expect another 0.25% cash rate cut next month on Melbourne Cup day, followed by a cut to 2.5% in the March quarter next year.
Based on the assumption that the RBA cuts interest rates further, the global economy stabilises and growth in China stabilises around 7.5% next year, then Australian economic growth should pick up again by the end of next year.
There are a number of implications for investors.
Interest rates need to fall a lot further. This means that term deposit rates are likely to fall further in the years ahead, even though the size of the decline will lag that of the official cash rate for bank funding reasons. As a result, the attractiveness of bank deposits for investors will continue to deteriorate.
Source: RBA, Bloomberg, AMP Capital
While record low bond yields mean bonds are poor value for long-term investors, yields will likely remain at the low end as the RBA cuts interest rates. However, if foreign investors start to panic about Australia, international bonds will do better than Australian bonds.
Australian shares should benefit from interest rate cuts and cheap valuations. As such we continue to see the Australian sharemarket being higher by year end. Key sectors likely to benefit from lower rates are retailers, building materials and home builders.
Declining interest rates in Australia will take pressure off the Australian dollar. However, falls are likely to be constrained by quantitative easing in the US and central bank buying. Overall, we see the Aussie dollar stuck in a range around $US0.95 to $US1.10. The best has likely been seen for the Aussie dollar.
Dr Shane Oliver is the head of investment strategy and chief economist at AMP Capital. Please note that this article is intended as general information and not as investment advice.
