Since the start of this calendar year, and certainly since the Federal election, the topic of interest rates, and what direction they will move in, is always popular at social and business functions. Maybe it’s an easy topic for small talk, as everyone has an opinion and people are really interested in knowing (or guessing) the movement up or down and which central bank will be next to cut.

Interest rates impact all aspects of the economy and the financial markets, so having an understanding is important. The key drivers for monetary policy are usually softening domestic outlooks, falling annual growth rates and expectations, low inflation and weakening business and consumer confidence.

Here in Australia, the first Tuesday of each month becomes a popular “will they (Reserve Bank of Australia) or won’t they”, move the official cash rate discussion. For a long time, there was no movement. Every other central bank was moving rates up or down, but the RBA was unmovable. Now since the Australian Federal election result the RBA has cut twice, both times 25bps.

The Federal Reserve in USA has just cut by 25bps, our friends in NZ cut 50bps this month. Most European countries have negative interest rates. About $15 trillion of government bonds worldwide now trade at negative yields according to Deutsche Bank.

Interest rates impact many areas of the economy:

• Interest received on deposited monies for savers and retirees (income).
• Deeming rates for pensioners.
• Interest paid on business loans and home loans (expense).
• International currency movements.

Interest rates impact areas of investment as well:

• Discount rate used in DCF, NPV and other analysis of valuation for businesses and share prices.
• Capitalisation rates used to value commercial property transactions and set yield rates for buildings.
• Income and capital values of fixed interest funds.
• Inflation impact and discussions around recession versus growth in the economy.

So, what does this all mean for the investor, the business owner and the consumer?

For the investor, the interest received on term deposits has fallen to between 1.6% and 2.2% for durations from one month to twelve months. The real interest rate for this investment would be close to zero, or even negative, when the real cost of living expenses is considered. The danger here, is that investors, regardless of age or risk profile, will start to chase higher yields and consequently put “monies at risk” in order to earn more. Understandable but dangerous.

Investors rotate from cash to equities, because there is no other alternative, or move cash allocations into higher yielding fixed interest funds or credit funds without understanding what these funds invest into (junk bonds or property mortgages). Even more dangerous.

Investors really need to do their homework before investing into these so-called defensive assets.

For the business owner, lower interest rates can be beneficial, as borrowing costs come down. Interest paid on borrowings is less, so more capital can be allocated to investment decisions, or more profit is made that can be reinvested back into the business. This concept means the economy grows and that inflation will reappear, then employees get wages growth and the economy continues to grow. But since the GFC this playbook has not quite gone according to script.

Inflation has not reappeared, wages growth has been subdued, due to spare capacity in the economy, and businesses have been reluctant to reinvest due to weak sales growth, and increasing input costs, not being able to be passed on to consumers in the form of higher prices. The deflationary effect of new technology has also impacted.

In the US, companies have been borrowing to buy back shares rather than investing into their businesses. Not a productive use of cheaper funding and probably not what the Federal Reserve intended with lower interest rates.

For the consumer, lower interest rates may mean less interest paid on home loans, car loans and personal loans. Lower interest rates are hopefully a spur for the housing market to reignite or at least stop falling in prices and activity. This is too early in the process to review. The RBA would also like the consumer to keep spending to help assist with economic growth. With such large personal debts assigned to households, any small reduction in home loan interest rates may just lead to consumers paying down existing debt or assisting in paying the addition real cost of living expenses, which seem to be increasing faster than the official CPI rates released by the ABS.

So, what is the bottom line?

The traditional playbook of the central banks may need to be rewritten, as the traditional outcomes are not eventuating. It seems the interest rates will be lower for longer and potentially negative for some time. Investors need to do their homework on the different asset classes and to take high yields not as a given but as a red flag. Chasing yield can lead to paying too much for shares in certain companies, so further research into these companies, considering free cashflow and the ability to pay constant dividends is essential. Discussions with your financial adviser on how to reset household budgets for a low interest rate environment, or where to reallocate defensive asset allocations, is a must and very worthwhile.

Businesses have the tough balancing act of investment decisions on organic growth, or acquisition growth, or a combination of the two. Is cheap credit going to be beneficial to my industry/business and how do I take advantage of the situation? There is no point taking on additional debt for unprofitable expansion, by paying too much for something or not having sufficient infrastructure to support expansion – it never ends well.

Consumers need to understand how best to allocate additional monies, if their home loan rates have fallen or additional wage growth has been achieved. Consumers are investors too, so asset allocation reviews are worthwhile, so hard earned gains are not lost due to inappropriate investments.

The interest rate discussion is unlikely to disappear any time soon. Interest rates impact everyone, so please take the time to discuss your personal situation with your financial adviser so you can make informed investment decisions.

The information contained in this article is of a general nature and does not take into account personal circumstances. Before making any decisions based on the factual information contained in this document please consult with your financial adviser.