Both long and short rates could go lower

MOST Australians focus on either the home loan rate or the term deposit rate. Yet these popular benchmarks are driven by many interrelated influences. The world of interest rates is far more complex than most realise. 

Investors can stick with term deposits and avoid understanding everything else. However, there are benefits in learning a little about interest bearing securities and their behaviour. 

For example people who invested in safe government bonds and bond funds over the last year have earned eight to 10 per cent and more, double the term deposit rate. How is that possible? 

Government bonds increase and decrease in value by small amounts over time as interest rates change. If you own a government bond that pays a high interest rate and rates fall your bond will become more desirable and valuable. You can sell it for a capital gain. 

That’s what has happened recently. A few years ago Australian ten year government bonds were paying six per cent. Their yield has now fallen to about three per cent. People holding bonds and bond funds have not only been paid six per cent interest but their bonds have also appreciated in value. 

Hence the ten per cent return over the last year. Of course there can also be losses. If rates rise and you hold a low yielding bond its value will decline slowly. 

So what is the outlook for interest rates? The current rate of around three per cent on Australian bonds is low compared to historic levels so some people think rates could begin to rise again soon, causing losses. 

However the reason rates have halved is bond rates in Europe and the US are 1.5 to 2.0 per cent. At 3.1 per cent our bonds are still attractive. They’re also triple A rated, the safest there is. 

Foreign central banks and institutional investors have been queuing up to buy our bonds. Central banks have bought them to hold as part of their international reserves. Almost eighty per cent of our bonds are now owned by overseas investors.

Because of weak major economies since the global financial crisis official short term rates in major countries are near zero. Our RBA cash rate is well above others. If the economic recovery remains slow overseas and commodity prices remain subdued pressure will build on the RBA to cut rates more. 

Inflation is also a key factor in interest rates. Low rates stimulate economic growth but if they remain low after the economy picks up shortages develop, wage demands increase and costs rise, creating inflation. 

That is a big fear of long bond holders. The bonds lose their purchasing power, or real value. On any sign of inflation the trading prices of bonds begin to fall and income yields rise.  

Increased money supply can also cause inflation.

Central banks have to manage this. Because of all the money creation and low rates over the last few years economic theory says there is a risk of rising inflation but no evidence of it has appeared yet. Meanwhile there are those who argue that both short and long rates will go still lower in Australia. 

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