On the first Tuesday of every month, the Reserve Bank of Australia (RBA) meets to decide what the current cash rate should be. The cash rate, currently at a record low of 1.5%, has a flow-on effect that directly impacts every financial aspect of your life, from your mortgage payments to your investment portfolio.
So… What is the Cash Rate?
The RBA describes the cash rate on its website as, “the overnight money market interest rate.” Put simply, this is the interest rate that banks pay on the money they borrow.
At the end of each day, banks transfer money between each other to settle outstanding transactions. But, believe it or not, they do sometimes run out of cash. When that happens, the bank must borrow money overnight from the RBA. The cash rate is the interest the bank pays on this overnight loan.
How Does it Effect You?
One of the ways banks make their money is through spreads; the gap between the rate at which they lend money, and the rate at which they borrow money. So, when the cash rate is high, expect to pay more interest on your mortgage or your personal loan.
However, it’s important to note that the banks aren’t obligated to pass on rate changes to consumers. When the RBA’s cash rate is cut, the banks don’t always lower their lending rates. Similarly, banks have been raising mortgage rates lately even though the cash rate hasn’t changed. This has to do with foreign interest rates and overseas borrowing costs, so there are other factors that come into play. But as a rule, when rates go up, expect your loan repayments to go up as well.
What About My Investments?
The most obvious impact on an investment portfolio will be the effect on your bond yields. Bond yields, especially government bonds, follow the cash rate quite closely. Because the cash rate is at a record low, government bonds are only yielding 2-3%. This graph shows the relationship between the cash rate and bond yields.
Source: Pacific Star Financial Planning
The cash rate can also affect your share portfolio. The effect that interest rate changes have on your portfolio will vary for each sector. For instance, financial companies, such as banks, brokerages and insurance companies can often see a decline in share price when the cash rate is lowered, because it usually means they will have to lower their lending rates, reducing revenue.
Other companies, like those in the consumer discretionary sector, tend to lose when interest rates go up. High interest rates leave consumers with less disposable income to spend on the goods these companies provide.
With all of this in mind, the cash rate is clearly important to investors when valuing portfolios of shares or bonds, and to consumers choosing between fixed or variable rate loans. For more information on the current cash rate, have a look at this article on the most recent RBA update.