Interest rates both globally and in New Zealand have started trending downwards. The US Federal Reserve reduced interest rates on the 1st of August 2019 for the first time in 10 years, the last time being during the financial crisis. They subsequently reduced rates twice more up until 30 October 2019. This follows similar moves by a number of other central banks, including the Reserve Bank of New Zealand in May and the Australian Reserve Bank in both June and July. The Reserve Bank of New Zealand acted again in August and surprised markets by reducing rates by a further 0.5%. These rate reductions have been taken to try and promote economic growth.
The global economy is showing signs of slowing
The global economy has been showing signs of slowing down over the last year or so following a sustained period of growth. A number of economists have also been predicting increasing chances of a future recession. The concerns over future economic growth have been caused by a number of factors, but it’s certainly been contributed to by trade tensions, such as between the US and China, and political uncertainties such Brexit and the rise of popularist politics. Signs of potentially lower future growth, have included stubbornly low inflation, reduced confidence of manufacturers and company earnings growth disappointments. However, there have also been contradictory signs indicating improving economic conditions, such as increasing employment and growth in wages in many developed markets.
Why do central banks reduce interest rates?
The actions taken by several central banks to reduce interest rates have been designed to foster increased economic growth by reducing the cost of borrowing. This is intended to encourage spending. Some central banks have gone as far as having 0% interest rates or even negative rates, such as the European Central Bank (which has a -0.4% rate on deposits, meaning that you pay the bank to hold your cash) and the Bank of Japan (which has a -0.1% deposit rate). The chart below shows the historic cash deposit rates for selected central banks.
How different types of asset classes react to a reduction in the cash rate (for New Zealand we are referring to changes in the Official Cash Rate), or the increased potential for further reductions in the rate, is complex. However, the general implications are considered below:
- Impact on cash – returns will fall, broadly in line with the reduction in central bank rates. Central banks are the ultimate lender to the high-street banks and other financial institutions, so if the rates applied by central banks reduce, then interest rates offered on bank accounts and term deposits will also reduce.
- Impact on fixed interest (also known as bonds) – Bond yields and prices are set with reference to the expected future path of cash rates, not just the current cash rate. If future economic growth is expected to be low, as it is currently, then the cash rates in the future might be expected to be low. Low cash rates provide for low bond yields and high bond prices as these are inversely related. How markets react to a change in the cash rate is often more driven by differences between what the market expects to happen and what actually happens. Thus, a widely expected change in the cash rate should have very little impact on bond yields and bond prices.
- Impact on shares (also known as equities) – generally, when interest rates are reduced, equity markets see this action as giving increased support for economic growth and future corporate earnings. Just like bond markets the reaction to a change in the cash rate depends upon whether the change was anticipated. For example, if the markets already think that the chance of an interest rate reduction is high, this will already be taken into account in share prices.
- Impact on property – Reducing central bank rates mean that it should become cheaper to borrow money. Generally, this would be expected to lead to an increase in the value of property over time, as with reduced cost of borrowing it’s possible to pay a higher price for property. However, the reality is more complex than this, with commercial property (such as offices, shops and industrial property) generally priced based on the cash rate, plus a margin for risk and an allowance for rental growth. This means that lower interest rates will only lead to increases in prices if the risk appetite and/or views on future rental growth remain unchanged or increase. Also, like equity markets, the property market can be complicated, and the value of property can be heavily influenced by other factors, such as supply and demand.
- Overseas assets – when the central bank of a country reduces interest rates, its currency is less attractive compared to other currencies and it should devalue to some extent. This devaluation has little impact for currency hedged overseas assets as the hedge immunises the asset from the currency change. For assets that have not been currency hedged their value can increase significantly. Typically, overseas bonds are hedged and overseas shares are often partially unhedged. For example, for the Aon KiwiSaver Scheme, most overseas shares have hedging targeted at 50% (meaning that 50% of the movement in exchange rates would be offset by the change in the value of the hedging).
What does this mean for Aon KiwiSaver Scheme?
Central bank proactiveness to support economic growth can fend off, or postpone, a potential recession. Their actions will influence the value of KiwiSaver investments more in the short term if the action is unexpected, or more aggressive than expected.
The impact of any market developments is different for each asset type, and the size of any change is dependent upon the asset allocation and strategy of the fund a member has invested in. Generally lower risk funds will hold more bonds and can be expected to offer lower returns in the future. The more aggressive funds may comparatively own more equities and other assets which may be volatile, as it is likely to remain unclear if recent cash rate changes have provided too little/too much support for economic growth.
Aon KiwiSaver Scheme is a retirement savings plan and when choosing a fund it’s important to consider your attitude towards risk, as well as how long you have until retirement and what your retirement objectives are. To help understand your attitude toward risk, and find out which fund might be right for you, complete our risk profiler.