What Impact Will Higher Interest Rates Have in Australia?

Higher interest rates?
Photo: Redspotted, Creative Commons

There seems to be an awful lot of confusion about the role interest rates play in Australia.

The house price crash cheerleading squad sound particularly puzzled.

On the one hand, they say there will be a huge spike in unemployment in 2014, leading to a sharp property downturn – which may or may not be true.

On the other hand, they say that higher interest rates will also return in 2014, resulting in the same thing.

Either one or the other of these statements might be true, but it’s not likely to be both.

For the reasons I discussed here, the prospects for our economy are ultimately dependent on the strength of the labour force, and it seems unlikely that we will get higher interest rates until there is sustained evidence of an improvement in employment data.

Unfortunately, with mining investment set to decline through 2014, futures markets don’t yet imply that the Reserve Bank is in a position to implement an interest rate hike – perhaps not even until early 2015.

However, given the level of confusion, it might be worth recapping the impact higher interest rates could have on Australia should they eventuate earlier than forecast.

Nine Occurrences That Could Take Place Due to Higher Interest Rates

1. Higher Monthly Mortgage Repayments

Firstly, and perhaps most obviously, there would be higher variable rate monthly mortgage repayments for homebuyers, mopping up more of their available household income and reducing the dollars that they have available to spend elsewhere.

2. Weak Dwelling Price Performance in Some Markets

As I see it, a hike in interest rates – and the associated expectation of further increases – would likely kill off material dwelling price growth in markets that have failed to build any momentum. 

Everyone has their own opinion on dwelling prices. Mine is that a hike in interest rates could make for ongoing weak dwelling price performance in Hobart, Adelaide and certain regional markets. Canberra also faces challenges of a slightly different (although not unrelated) nature, which are tied back to the probable shrinking of its labour force.

“A hike in interest rates could make for ongoing weak dwelling price performance in Hobart, Adelaide and certain regional markets.”

On the other hand, a speculative beast has been unleashed in the Sydney housing market, which a solitary interest rate hike may not be able to tame.

In fact, based on what I’ve seen at auction over the weekend, any market intervention at all is unlikely to stand in the way of the seemingly unstoppable momentum.

Note that as a Sydneysider I have a clear vested interest in this market, and therefore it makes far more sense to pay heed to what others forecast for our markets. That said, anyone who is based in Sydney will know exactly what I’m referring to – auction bidding frenzies, a proliferation of investors (with funds flowing from Sydney, inter-state and from overseas) and well-located properties in many cases selling for large margins above reserve.

3. Higher Borrowing Costs for Industry

Higher interest rates would result in higher borrowing costs for industry. Correspondingly, higher interest rate charges will impact bottom line profits and potentially discourage companies from proceeding with marginal projects.

4. Higher Borrowing Costs for Individuals

Similarly, other borrowing costs for individuals would increase for personal loans and credit cards, which eventually should impact consumer spending adversely (although the correlation may not immediately be as strong as it ought to be).

5. A Fall in the Value of Ordinary Shares

Due to lower corporate profits there may also be a fall in the value of ordinary shares, although the share market is clearly more complex than that and momentum will as ever play a key role here too.

In particular, value-orientated investors (as opposed to technical traders and speculators) are likely to weigh up the relative merits and yields of other available investments.

6. Stronger Returns for Savers

On the plus side, higher interest rates see stronger returns for savers and increase the returns that investors should typically expect to see on their money. This would be a relief for many pensioners who often prefer lower risk assets such as certain types of term deposit.

7. A Stronger Aussie Dollar

All other matters being equal, higher interest rates could see a return to the strengthening of our currency – the Aussie dollar – as overseas investors acquire assets to take advantage of higher returns.

8. A Fall in the Price of Bonds

The price of bonds would also fall unless (a) the market and investors only see rising interest rates as temporary or (b) the interest rate rises have already been fully priced in.

9. A Greater Opportunity Cost for Holding Non-Yielding Assets

Finally, there would be an even greater opportunity cost for holding non-yielding assets such as gold or other commodities.

In theory, it becomes more expensive to hold gold (in addition to the storage and insurance costs that already make gold an unattractive investment) as rates rise because with higher interest rates investors are losing the opportunity to secure stronger yields elsewhere by instead choosing to hold a shiny lump of metal.

A fund manager might hold 2 per cent of a portfolio in gold as a speculative bet, but taking too large a position introduces a material opportunity cost.

The same case can be made against residential property, of course. The most compelling reason why individual investors tend to look to property – apart from sticking to what they know – is the double-edged sword of greater available leverage.