Rising interest rates, what does it mean for investors?

For the first time in over a decade, the RBA has raised its official cash rate.

In lifting rates, the RBA appears to have partly accepted they needed to do something decisive to put the brakes on rising inflation.  In its commentary, the RBA indicated it would ‘do what is necessary’ to return inflation to target and that this will likely require further interest rate increases.

Banks have started to pass the RBA’s rate hike on in full to their variable rate customers and deposit rates will also start to rise.

While rising rates will cause bouts of uncertainty and see economic growth slow down it is unlikely the magnitude of rate rises this year will be enough to end the economic recovery and trigger a recession.

What does it mean for the share market?

There is an ambiguous relationship between rising interest rates and the Australian share market. While higher rates place pressure on share market valuations by making shares appear less attractive, early in the economic recovery cycle this impact is offset by still improving earnings growth.

Several considerations are worth noting.

Firstly, rising rates from a low base are normally not initially bad for shares, as they go with improving economic conditions.

Secondly, rising interest rates are only really a major problem for shares when rates reach onerous levels contributing to an economic downturn. They are also a problem when rate hikes are aggressive, as in 1994 when the cash rate was increased from 4.75% to 7.5% in four months.

Third, if the RBA cash rate rises to 1.5% by year end, deposit rates would still be less than 2%, so they will still be low relative to the grossed-up dividend yield on Australian shares of around 5.5% leaving shares relatively attractive.

Finally, given the high short-term correlation between Australian shares and US shares, what the US Federal Reserve does is arguably far more important than local interest rates.  Overnight the Fed lifted rates by 0.50%, the highest rate increase since 2000 and the share market jumped by 3%.

So, modest rises in Australian interest rates are unlikely on their own to derail the share market. But an environment of rate hikes will result in a continued period of volatility for shares short term.

What about property prices?

The rise in Australian house prices over the past decade has been nothing short of phenomenal, owing to cheap borrowing, strong employment, and a healthy banking system eager to lend.

Housing forms the most significant single component of many household balance sheets (on both sides of the ledger), and housing valuations are a key driver of Australians’ net wealth.  Highly leveraged households, driven by the low cost of borrowing, have a magnified sensitivity to changes in interest rates. 

Because the Australian property market is highly sensitive to interest rate changes as a result of very high prices and debt to income ratios, higher rates are likely to cool the property market.  If rates rise were to rise sharply there could be significant falls in property prices as borrowing becomes more expensive and repayment pressures increase.   If that were the case, there would be negative implications for household wealth, consumption, financial stability, and for the broader Australian economy. The RBA is keenly attuned to these risks and will have the housing sector and household finances, front of mind during their monetary policy decision making processes.