7 Ways Higher Interest Rates Could Reshape Our Economy

We are currently in the midst of an unprecedented worldwide economic experiment. Since the global financial crisis, the central bankers of the largest economies in the world have slashed interest rates to zero, and in some cases, even below zero.

The aim has been to increase the supply of money by incentivising banks to lend more freely.

The ultimate goal is to get businesses and households to borrow, invest and spend, rather than playing it safe by keeping their cash in the bank. Keynesian economists believe this is the key to continued economic prosperity.

As a result, Australia has been forced to follow the same easy money path in order to remain competitive in global trade. With a record-low two-percent cash rate, which is likely to go even lower, the RBA is fully engaged in a worldwide currency war.

No one really knows where this little experiment will take us, although we’ve seen from history that it hasn’t worked out too well for Japan. And since nothing fundamental seems to be improving in the U.S. or with the EU, there is little evidence that central bankers will dramatically change course any time soon.

Given enough time; however, as RBA deputy governor Philip Lowe recently warned, we can be sure that interest rates will rise.

Whether by central bank intervention or unstoppable market forces, higher borrowing costs are inevitable. Thanks to the statistical certainty of mean reversion, we know that someday interest rates will return to their historical average.

How high will interest rates go? To answer that question, let’s examine the history of interest rates:

• The average standard variable home loan rate in Australia from 1990 to 2010 was 8.54 percent. That’s about double where we are today.
• As recently as January 2009, mortgage rates were over nine percent.
• If history is our guide, we could overshoot the 8.5 percent mark in a correction. During the late 1980’s, our mortgage rates spiked as high as 17 percent.
• The average interest rate in the 1980’s was 13.2 percent.

Just to put this data into perspective, let’s work through a little example, assuming you’re the typical Aussie homeowner:

• The average mortgage in Australia is about $450,000. At 5.5 percent, on an interest-only loan, that’s $24,750 per year in interest costs. Most households today can manage that.

• At 8.5 percent; however, you’d be looking at $38,250 per year. This is a highly likely scenario that would drain an additional $1,125 per month out of the average family’s budget.

• Based on the historical high of 17 percent, you’d be paying $76,500 per year in interest alone. Assuming you didn’t default on your mortgage, you’d be forced to find an extra $4,300 per month, just to keep your home. And you’d still be $450,000 in debt, unless you were also paying down the principle.

Just for a moment, think through the implications of such an economic shift upon your life. Consider these questions:

• How would higher interest costs change your current spending habits?
• How would your lifestyle be affected?
• What would you be forced to sell?
• What could you no longer provide for your children?
• How would you cope emotionally?

Thinking through these questions can help to open our eyes. We can begin to see that many of our current expectations and lifestyle decisions are based primarily on the fact we are living through the great economic experiment of artificially low interest rates.

When interest rates eventually rise, here are seven major changes you can expect, which would dramatically reshape our economy:

1. Borrowing Costs Will Rise

This is the most obvious impact of rising interest rates, but it doesn’t stop there:

• Your spending habits will have to change. Those who are in the unfortunate position of indebtedness will have less disposable income as they are forced to spend more each month on interest payments. Whether it’s the mortgage, credit cards or other consumer loans, those who owe money will feel the most pain.

• If interest rates spike dramatically, many Australians could lose their homes. Investors who have redrawn equity to buy more properties may likewise face foreclosure, or at best be forced to sell their properties at a loss to cover their debts. Unrealised equity gains, which have defined wealth in our culture, will vanish.

2. Cashed-up Savers Will Be Laughing All The Way To The Bank

As interest rates rise, so do the risk-free returns available by parking your money in a savings account. Back in the 1980’s term deposits were paying over 14 percent. Could you imagine earning $70,000 per year on $500,000, risk free?

While that’s an extreme scenario, even an eight-percent risk-free yield from a savings account would be remarkable.

3. Asset Values Will Decline

As the risk-free rate of return increases, investors will be less willing to own shares and real estate. The risks of vacancy and the loss of capital simply wouldn’t warrant it. This means:

• Equity markets will suffer. Shares will take a massive hit as investors pull their wealth out of the equity markets in favour of the security of a savings account.

• Higher interest rates means fewer people can service mortgage loans. The flow of credit into the housing market will diminish, taking away the primary reason real estate is so expensive.

• With fewer homebuyers in the market, demand will dry up. Sellers will be more desperate, so home prices will fall.

4. The Australian Dollar Will Likely Appreciate

Just as lower interest rates lead to a depreciating dollar, so rising borrowing costs can cause our currency to get stronger. This will have two primary implications:

• International investment activity will increase. If our rates rise higher than those in other countries, international investors will be more likely to stash their cash in Australian banks. This increased demand for Aussie dollars would cause our currency to become more valuable.

• A stronger aussie dollar will make our exports less attractive. Our goods and services will cost more relative to other currencies. This would hurt our balance of trade, increasing our trade deficit, as we would be motivated to import more goods, while exporting less.

Bear in mind however, that the full impact of interest rates upon our dollar would depend upon rate activity in other countries as well. The Aussie is typically priced relative to the U.S. dollar, the world’s current reserve currency. If interest rates are rising at the same time in the States, their currency should also appreciate, which would mean the value of our dollar might not change dramatically.

5. The Demand For Goods And Services Will Decrease

With families forced to make higher debt repayments and with less discretionary funds, consumer spending will decline. As a result, the demand for goods and services will decrease, causing the following domino effect:

• Companies will produce less, meaning some will go out of business.
• Commercial real estate will suffer higher than normal vacancy rates.
• The economy will slow down and may even contract.
• Businesses will aggressively compete for the fewer dollars that are changing hands.
• Our economy will experience deflation, as the prices of many goods and services may decrease. This could be the silver lining for cash-strapped consumers.

6. Unemployment Will Rise

A slowing economy will lead to higher rates of unemployment because:

• Companies will produce fewer goods and services, so they’ll need fewer workers.
• Some companies will go out of business, leading to job losses.

Wages may also decline, as people become more desperate for work and are willing to accept lower pay.

7. Government Debt Costs Will Increase While Revenue Falls

Higher interest rates will cause bond yields to go up, leading to an increase in the cost of the Government’s borrowings.

The Australian national debt is now over $425 billion, making our nation’s current annual interest payments about $9 billion.

If bond yields were to spike to 4.5 percent, that repayment amount would more than double. At 14 percent, the Commonwealth would face about $60 billion per year in borrowing costs.

Even a moderate surge to 8.5 percent would be painful, because:

• All of this would happen at a time when unemployment is on the rise and consumer spending is dropping.
• Since both businesses and households would earn less, the government would collect less revenue in the form of tax dollars.
• Government spending would tighten up, meaning family payments would likely decline, and investment in infrastructure would diminish.
• Over time, this could even mean higher taxes, because politicians would have to seek to recover the shortfall, just to keep the nation afloat.
• Higher taxes would put an even tighter squeeze on household budgets, and increase the likelihood of social and political unrest.

How You Can Prepare Now

Go ahead and face the fact that at some point, we can expect a recession. The money supply will contract, and there will be less of it moving around in the economy. It may be three, five or 10 years from now, or maybe even longer, but it is coming.

As I wrote about here, we should recognize market corrections as a normal part of a healthy economy. Ideally, when the market is left to itself, these periods of adjustment should be relatively painless.

Unfortunately, the economy isn’t influenced solely by supply and demand. Market distortions due to monetary and fiscal intervention are the new reality.

No matter what central bankers do to avoid economic corrections, they are a certainty. While regulators can kick the can farther down the road, they are only prolonging the inevitable, and can often make the corrections much more dramatic and painful once they do occur.

As legendary investor John Templeton famously said, “Bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria.”

The best investors position themselves to buy at the point of maximum pessimism. To do so, you must see the death of the market before the majority of other people do.

Here are three things you can do now to prepare yourself while the market remains moderately euphoric:

A. Stress Test Your Asset Portfolio

Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.”

Buffett’s point is that investors should consider the outcome of an unfavourable economic shift. If you’re swimming naked, but don’t yet realise it, it would be helpful to know before you’re exposed to the elements and it’s too late. Ask yourself this:

• If your borrowing costs were to rise by two percent, how would that impact your cash flow?
• What if rates rose to the historical mean of 8.5 percent? How would you be affected then?

B. Pay Down Your Debts

When interest rates are low, debtors win. When interest rates rise, savers regain the advantage, and debtors lose.

In the United States, it’s possible to lock in a 30-year fixed rate mortgage. Australians are not afforded that luxury. We carry a higher degree of interest rate risk.

If you’re inclined to believe that interest rates will move higher, wouldn’t it be wise to stop borrowing to buy assets, and to start reducing your current debt exposure?

C. Build Up Your Cash Reserves

Because cash is king when interest rates are high, if you expect monetary policy to tighten, or Australia’s credit rating to drop, it would make sense to cut expenses and save cash.

You could use this cash reserve as a buffer against higher interest costs. Rather than dramatically tightening up your lifestyle, you may be able to weather an economic storm by drawing from your own savings.

A higher interest rate environment tends to lead to depreciating asset prices. Therefore, option two would be to use your reserve of capital to purchase higher yielding assets after asset prices correct.

Conclusion

While these preparations may seem dramatic to many people, everyone needs to recognise two crucial points:

• We are living in unique economic times.
• These times can’t last forever.

Perhaps the Keynesians can achieve the soft landing we’re all hoping for, but since there’s no guarantee they will, we need a clear mental picture of what a hard landing would look like.

One final word of caution: while we can be certain higher interest rates will come, we can’t be sure exactly when they will come and how long they will last. And there’s the rub. The ideal timing of your exit from inflated assets is the all-important question. Ultimately, only you can make that call.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.