The Hidden Impacts Of Rising Interest Rates

After the all time high of 17.5%, interest rates have been in a steady decline since January 1990. The official cash rate has increased to 3.6% from the measly 0.1% if was 3 years earlier.

You might think that a 3.5% increase is not as big as 17.5%, but 0.1 to 3.6 is a 36 times increase. A whopping 360%.

To understand interest rates, we have to understand how the economy works. To narrow this field, we need to understand how banks operate.

There is a saying the investment world, that the stock market does not reflect the economy. You only have to watch the stock market to ascertain the truth in this.

However, not all is lost as there is a way to get a hint about the economy. That is to watch the banks closely.

Banks are an integral part in the modern economy. Without banks, the economy will not operate as it does today.

Central banks control money supply, and then the banks facilitate the flow of money into the market. They are essential in keeping the engines of an economy running.

We have to understand that interest rates and the official cash rate and not the same thing. The official cash rate is the overnight rate at which banks lend to one another.

If the cash rate increases, it becomes more expensive for banks to do business. How do they maintain their margins? By passing on the cost to borrowers in the form of higher interest rates.

So with interest rates rising and predicted to continue to rise until 2024, what are the hidden impacts that normal people like us don’t see?

Interest Rates On Asset Valuations

Interest rates to asset are like gravity to humans. The larger it is, the heavier it weighs down on us. With interest rates so low for so long, asset valuations seemed like they would grow to the sky.

Warren Buffett on an interview with CNBC was quoted saying that ‘if interest rates remain this low, stocks are cheap’. However, interest rates are no longer low and by definition asset values are no longer ridiculously cheap.

As interest rates rise, investors start to demand a higher return premium for taking on additional risk. They can only get a higher return if asset prices are lower than their current prices.

This not only translates to stocks but most assets like property, cash, and bonds. You can bury your head into the sand as strategy to overcome this situation. But the reality is that the majority of Australians will be impacted by this.

Even if you do not directly invest into these assets, every capable working class Australian has a superannuation account.

And that superannuation account depending on your selected structure will have a mix of those investments. If higher interest rates weighs down on asset valuation, you can almost guarantee your super balance will be affected aswell.

While we are on this topic, let us not ignore the giant elephant in the room that Australians love their property. Better yet, most Australians wealth is tied to the value of their property.

Unless you are forced to sell your property or already in retirement, you may be able to get through momentary devaluation of asset prices. But the reality is, even if you don’t see it there are impacts with rising inflation.

Watch The Retail Banks

What do banks have to do with all of this? As we all know, banks are important and large oligopolies. We have a love hate relationship with them.

On the outside it might seem simple how banks operate, but do we really understand how interest rates really affect them? And in turn affect us?

Australians have had a slight break with a pause in interest rates hike at 3.6%. Whereas our counterparts in New Zealand and the US and other major countries have continued the rise. You might be thinking, aren’t we lucky.

Well…. yes and no.

What we have to understand about banks is that their main product is money. And the only product they sell is, money.

They are not interested in your home, your car or your yacht that they hold as collateral. What they are concerned about is getting back their money they loaned to you.

Australian depositors make up roughly 50-60% of deposits into the bank. That is funding that banks have to loan money out. However, our population is not large enough to provide the sufficient capital to continue lending.

Which brings us to the wholesale market, where banks get funding from banks from other countries. These balances may range from 25% – 40% of a banks balance sheet.

In a scenario where the Australian Reserve Bank decides to not raise interest rates again. But the Central Bank in America decides to continue. We as Australians are not safe from bank interest rate increases.

Because funding also comes from other countries. Australian banks will face increase cost of borrowing which they will still have to pass on to their borrowers.

For example, to make it simple. If 50% of a banks funding comes from Australia and 50% from overseas. If Australia’s interest rate is 3% and overseas market is 5%, the cost for banks to borrow is 4%. So even if the official rate in Australia is 3%, the banks face a 4% borrowing cost.

Interest Rates Give Rise To Hidden Poverty

Debt to income ratio is usually the measure people use to see how much financial stress borrowers are in. However, a better measuring stick to use is repayments to income ratio.

While the debt to income ratio of families have increased dramatically over the last century, interest rates have also fallen. But the bad news, this resulted in property prices to appreciate.

People are able to buy more expensive housing because their income is able to cover the lower repayments. The era of cheap credit has unfortunately come to an end.

While interest rates are rising and property prices have pulled back slightly, the original loan value has remained the same. Borrowers are now finding themselves is positions where their monthly repayments are eating away into their household budget.

We are now in Credit Card Nation, where we went from record high savings to record debt in two years. There is also growing concern that savings will be wiped out if interest rates remain this high for longer periods.

Home owners are not the only ones affected by these higher repayments. Looking at the 4 big banks balance sheets you can conclude that roughly 30% of loans are investors, 30% owner-occupier and another 30% is business.

So from this data we can deduce that 30% of people rent, 30% hold a owner-occupier mortgage and another 30% own their property outright.

So out of the newer home buyers in the 30% more sensitive to rate rises, 30% of renters also face increase cost pressure from rent raises.

When interest rates and inflation rise faster than wage growth, there will be some consequences to be faced.

Key Takeaways

• Interest rates are not as straight-forward as you think. With the global economy so inter-connected we have to look at other countries to get a better picture
• Studying what the banks are doing can give you a better picture into the direction of an economy
• Leverage is the only way an intelligent investor can go broke

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