What's going on with interest rates?

In a week where pretty much everyone bagged the RBA for not reducing the cash rate, it would come as a bit of a surprise that one of the major banks would actually go ahead and INCREASE their variable rate.  But that is what the bright sparks at ANZ did at their 'out-of-RBA-cycle' meeting last Friday.  It's not a massive increase - only 6 percentage points (0.06%), but it an increase all the same.  To make matters worse, the other 3 big banks outdid ANZ by increasing their rate by up to 10 basis points.  So why is all this happening?  Why do we expect an interest rate decrease by the RBA, only to find the big banks actually increase their rates?

The case for an RBA rate decrease

Many people were expecting the RBA to reduce the cash rate by 25 basis points on Tuesday, and just to keep us on our toes they decided to ignore that sentiment and left the rate on hold.  If you were watching the announcement live on Sky News (as certain nerds in this office do), you would have noticed that as soon as everyone found out that the rate would not be lowered, the graph on the right of the screen suddenly spiked upward.  This was the Aussie Dollar compared to the US Dollar - or AUD/USD currency pair.  At the moment, a higher cash rate means a stronger Aussie dollar,  so up it went from about US$1.07 to $1.08 in the space of a microsecond.  Many people expect it to get up to $1.10. 

 Who benefits from this?

• Currency traders who predicted the RBA would not reduce the cash rate.
• Aussies travelling overseas, as now that dollar is going to buy more bottles of Bintang than it used to and the ski lift pass at Aspen is going to be cheaper.
• The people selling Bintang and lift passes as more Aussies will be spending more overseas.
• Importers who can bring more goods into the country more cheaply.
• Foreign exporters who are selling goods to Australia and collecting a strong currency in return.

Who doesn't benefit from a stronger Aussie Dollar?

• Pretty much everyone else, but mostly exporters of Australian goods and services, such as
• Farmers
• Miners
• Manufacturers
• Tourism operators
• Education exporters etc

Basically, if your industry relies on foreign money, ie. foreigners buying your goods or spending their money in Australia, then you stand to lose a significant amount of business as Australia becomes more and more expensive for foreigners due to our rising dollar.

Now it is no coincidence that those industries that are going to be hit hard by a strong dollar are the exact industries that are already in trouble (with the possible exception of mining).  The Aussie dollar has been pretty strong for a while now which is why we are hearing more about car manufacturers closing down plants and moving to Malaysia where they can pay their workers less.  Even true blue Aussie banks (Westpac) whose ads try to make people feel that they are community oriented are slashing jobs and moving their call centres to India.  ANZ seem to be doing their level best to alienate everyone by now announcing that they are slashing 1000 jobs Australia wide.

So the case for a rate reduction was a very strong one.  It would not only help people manage their debt better by being able to make extra repayments, it would also encourage them to go out and spend those savings, thus propping up the struggling retail, tourism and hospitality industries.  Lower rates should translate to a weakening dollar which would also help exporters.  Alas, the RBA didn't listen and will now be almost certain to drop the rate at the next meeting.

The case for the bank's interest rate increases

I'm sure the big 4 won't be winning any popularity contests today or for the next week as news of their rate increases come to light.  I guess out of the big 4 banks, ANZ is probably the one bank that will weather the tide of backlash the best.  In my opinion, it still has the best overall Professional Package - good loans, flexibility, discounts, credit cards and offset accounts.  Their branch service is usually very positive and their staff seem friendly enough, most of the time.  Don't forget they only increased their rate by 6 basis points opposed to 9 basis points by NAB and 10 basis points for both CBA and Westpac.  But regardless of that, Friday's increase is not going to be a good look for them.  So why did they do it?

How can a bank put up the interest rate when the RBA didn't?  Well the truth of the matter is that for the most part, the RBA does not have a lot of bearing on how profitable a bank is.  Banks source the funds they lend out from a number of different places.  They encourage people to deposit savings by offering higher than usual term deposit rates; they borrow wholesale funds from Australia; and they also borrow wholesale funds from overseas.  It is the overseas funding from the international money market that the banks are blaming for the increased rates.  Without getting into too much economic jibber jabber, it is costing the banks more and more to borrow funds from overseas.

Unfortunately this has been slowly reducing the bank's profitability.  Boo hoo, poor banks.  How will they sleep at night knowing that they only made $5.2 billion profit instead of the $6.5 billion they were hoping for.  Our banks are excellent profit making machines, and regardless of the economic environment, they will always endeavour to make a tidy profit.  Which business wouldn't right?  In fact, if they didn't post a nice profit, their share prices would fall and their investors would leave them for the other banks that are making a profit.

What does it mean for you?

The outlook in Europe is dire and America and Japan are not much better.  Our saving grace in Australia is that China is still buying our minerals (though this has created a two-speed economy).  In light of this fairly gloomy global outlook, the RBA will try to stimulate the economy by dropping the cash rate which will encourage people to spend.  The next year and possibly more will see lower interest rates.  However, it is increasingly unlikely that the banks will pass all of these reductions on to you and me, mainly for the reasons outlined above.  Of course, there are far more complicated issues at play and my explanation can at best be described as 'basic'. 

My recommendation is equally basic: 

• While rates are low, pay as much off your home loan as you possibly can. 
• If you are concerned about being laid off, make sure your loan is structured in a way that will help you cope while you are looking for another job. 
• Regularly review your risk protection.  Your super and income protection policies could very well save you from default during a prolonged recession.
• Don't be afraid to call or email us here if you have any questions or would like referrals to financial specialists.