Interest rates threat that investors should note

Interest rates are likely to go up in the next 18 months, so what does this mean if you are in property debt up to your eye balls?

Well you could panic and start selling everything that might expose you, or you can just breathe, and take heed of the fact that anything too disruptive is still some way off.

The minutes of the Reserve Bank of Australia’s latest board meeting is likely to confirm that the next move in the official cash rate will be higher, but not for some time yet. Many economists believe it could happen later this year if economic conditions continue to improve. Currently the cash rate sits at 1.5 per cent.

This historically low interest rate has fuelled a property buying frenzy in Australia and as a result households are in more debt today than they were before the global financial crisis, yet that debt is being swamped by property wealth.

The average debt level per person has increased from $11,837 in 1990 to $93,943, while the average wealth (thanks to rising property prices) per person has climbed from $86,376 to $475,569.

Despite this AMP Capital chief economist Shane Oliver cautions investors that higher debt levels are increasing our vulnerability to changing economic conditions.

There are several threats he cites which investors would be wise to keep abreast of and they are:

1. “Higher interest rates – the rise in debt means moves in interest rates are three times as potent compared to say 25 years ago. Just a 2 per cent rise in interest rates will take interest payments as a share of household income back to where they were just prior to the GFC (and which led to a fall in consumer spending). However, the RBA is well aware of the rise in sensitivities flowing from higher debt and so knows that when the time comes to eventually start raising rates (maybe later this year) it simply won’t have to raise rates anywhere near as much as in the past to have a given impact in say controlling spending and inflation. And so, it’s likely to be very cautious in raising rates (and is very unlikely to need to raise rates by anything like 2 per cent.)
2. “Rising unemployment – high debt levels add to the risk that if the economy falls into recession, rising unemployment will create debt-servicing problems. However, it is hard to see unemployment rising sharply anytime soon.
3. “Deflation – high debt levels could become a problem if the global and local economies slip into deflation. Falling prices increase the real value of debt, which could cause debtors to cut back spending and sell assets, risking a vicious spiral.  However, the risk of deflation has been receding.
4. “A sharp collapse in home prices – by undermining the collateral for much household debt – could cause severe damage. Fortunately, it is hard to see the trigger for a major collapse in house prices, ie, much higher interest rates or unemployment. And full recourse loans provide a disincentive to just walk away from the home and mortgage unlike in parts of the US during the GFC.
5. “A change in attitudes against debt – households could take fright at their high debt levels (maybe after a bout of weakness in home prices or when rates start to rise) and seek to cut them by cutting their spending. Of course, if lots of people do this at same time it will just result in slower economic growth. At present the risk is low but its worth keeping an eye on with Sydney and Melbourne property prices now falling. But high household debt levels are likely to be a constraint on consumer spending.”