We have had low interest rates in Australia for a few years now and the RBA has just announced another cut of 0.25%. This makes the official cash rate the lowest in history at 1.25%. Rates are lowered when regulators see a need for the economy to be stimulated. Lower interest rates are good for the share markets as companies can expand by cheaper borrowing. However, it can also lead to some negative repercussions. These are the 6 dangers of low interest rates.
1.Returns on savings decrease
Low interest rates discourage investors from putting money in savings accounts. They use the funds to pay off debt or invest in property and shares. If depositors are only receiving 1.3% on cash management accounts, they are better off paying off the mortgage or investing in property or shares where the rate of return may be higher.
Hence banks are losing deposits and they need to obtain their funding elsewhere such as offshore wholesale markets.
2.Challenging environment for retirees
Retirees who rely on their investments to fund their living expenses would find the low interest rate environment challenging. Individuals who rely on interest from savings and fixed income would find returns on this asset classes low. If retirees are not generating enough interest to fund their lifestyle, they may decrease their spending. This can contribute to a slowing of economy activity. Or they may look at other riskier asset classes such as property or equities when seeking higher yield.
3.Encourages risk taking
In low interest rate environments investors need to take on higher risk to generate better returns. This may encourage them to look at riskier markets. That is, investors look to emerging markets to obtain good returns. This is because they are seen as high growth investment in an environment where high growth investments may be hard to find.
4.Low interest rate environments can create asset bubbles
In an attempt to create growth in a stagnating economy, the central bank may decide to cut interest rates. Low interest rates can make borrowing cheap which can then lead to asset bubbles. The problem with asset bubbles is the price of the asset starts to rise as speculative investors pour their money in the hope that the asset will continue to increase in value. The asset has not increased in value due to the underlying fundamentals but more on sentiment. When interest rates are low, borrowers can take on more debt which allows them to pay more for assets which then drives up the asset prices. We have already seen this with equities and property.
5.Lowers the exchange rates
When interest rates are lowered, it discourages investment in that currency. An investor can receive a higher interest rate in another country and therefore would move their money there. The effect of this is a lower exchange rate. This is good news for exporters as they can sell their products cheaper overseas but bad news for importers as it means their goods will be more expensive.
6.Lowers profitability of banks
Rates cuts decrease bank net interest margins which is the difference between the cost to borrow and the cost banks lend out. This can lower bank profits. In low interest rate environments, banks need to cut their lending rates to stay competitive. With the housing market now passed its peak, there is less positive sentiment in the property market which is also driving down demand for loans.
Lauren Hua is a private client adviser at Fairmont Equities.
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