Interest rate cuts – A double-edged sword
In September, South Africa’s Consumer Price Index (CPI) had been comfortably within the target range of 3% – 6% for 14 successive months, signalling the strong likelihood of an interest rate cut in September. The debate since wasn’t whether the repo rate would be cut, but rather what the scope of the reduction will be.
In its last update, the South Africa Monetary Policy Commission (MPC) announced a repo rate cut of 25 basis points to 8% per annum, effective 20 September 2024. The MPC considered options ranging from no change to a 50-basis point cut, ultimately agreeing on 25 basis points to support growth over the medium term. The forecast projects rates moving towards a neutral level next year and stabilising just above 7%.*
What does a rate cut mean for investors?
The quote often attributed to Albert Einstein acts as a good starting point – “Compound interest is the eighth wonder of the word. He who understands it, earns it; he who doesn’t, pays it”. Put simply – interest is earned on money in the bank, but paid on debt owed.
The indebted South African consumer
South Africans burdened with debt – whether it’s a home loan, car loan, or credit card bill – would have applauded the recent rate cut. Lower interest rates mean lower repayment costs, providing much-needed relief for many households. This extra money in the bank leaves more room in monthly budgets for everything from essential expenses to the occasional indulgence. This loosening of the financial belt may also provide a modest boost to the economy, as consumers spend a bit more and feel more confident about making larger purchases or investing in home improvements.
The invested South African
While investors in equities might cheer at the prospect of lower interest rates driving up equity prices (we unpack this further down), those dependent on investments that earn interest are likely to feel different.
For savers and fixed-income investors, the reality of a rate cut is less interest earned on their investments. As interest rates drop, the returns on savings accounts, fixed deposits, and other interest-bearing investments shrink. Retirees and others who rely on interest income to support their lifestyle may find themselves having to tighten their belts.
In a low-rate environment, even a modest return seems elusive, forcing many to consider riskier options. The frustration is palpable: you’ve saved all your life, and now the reward seems…well, less rewarding.
In Exhibit 1 below we illustrate the difference in the total loss of interest earned (accrued over 12 months, assuming rates will be held constant).
- The graph below illustrates the difference between R1000 invested at 8% and 8,25%.
- What is important to note is that the difference in interest earned by the investor over the 12 months isn’t as simple as having less money in the bank (i.e. R1086,95 is R2,72 less than R1089,67) but that the investor is earning R18,60 less due to the loss of interest that could have compounded if the interest was reinvested.
Exhibit 1 | Interest earned before the recent rate cut versus interest earned after
Source: Author’s own calculations. For illustrative purposes only.
Of course, neither of the above categories (being indebted versus invested) is exclusive. Both will require thoughtful consideration and planning. Those with more spending power must consider spending wisely and repaying debt sooner rather than later. Those with interest-bearing investments, should consider their investment asset allocation mix and diversify according to their specific needs.
Now, let’s explore the broader economic context of rate cuts
Businesses can expand, impacting local equities positively
Lower interest rates often serve as a boost for the equity market, as borrowing becomes cheaper for companies. With reduced financing costs, businesses can borrow more affordably, expand operations and/or pay down expensive debt. This makes their balance sheets look more attractive, pushing up equity prices and thereby possibly drawing in more investors looking for better returns.
Lower interest rates are particularly welcomed in sectors that thrive on growth and borrowing, such as technology, consumer goods, and infrastructure. As the cost of capital declines, investors tend to value stocks more highly, driving up prices even further.
Bonds give and take
While equities may increase in appeal, the bond market presents a different story. Lower interest rates mean newly issued bonds offer lower yields, reducing their attractiveness.
For investors holding existing bonds with higher interest rates, the value of their bonds increase since they now provide better returns compared to new issues. Yet, income-focused investors especially those reliant on predictable returns may find this landscape frustrating. As a result, investors tend to shift capital from bonds to equity in a low-rate environment, seeking the potential of higher returns that equities could offer.
Banks tighten their belts
Banks, which usually thrive on lending, may actually pull back in a low-rate environment, choosing instead to focus on more profitable business lines. While the equity market and bond market may seem to react in opposite directions to lower rates, the overall lending landscape can muddy the waters. As Borio et al. (2017) observed**, “low rates depress bank profitability by sapping interest rate margins,” creating a paradox where, despite lower rates, banks might become more cautious about lending.
Do rate cuts lead to more spending or more savings?
Conventional economic theory suggests that lower interest rates should reduce savings and increase consumption. After all, why hold onto cash when its value isn’t growing much? The idea is simple: lower rates should encourage spending and stimulate economic growth.
Reality, however, often tells a different story. As interest rates fall, rather than splurging, people tighten their belts, fearing future economic instability or simply wanting to ensure they meet their retirement targets. This behaviour is particularly evident among older consumers, who, having been raised in a higher-interest-rate environment, may find it difficult to adjust to the new reality. Instead of feeling encouraged to spend, they seek to bolster their savings to compensate for the lower returns. In this sense, the hoped-for consumer-driven economic boost doesn’t always materialise.
In conclusion
All of this underscores the complexity of monetary policy in a low-interest-rate world. With this being said, the current repo rate (at 8%) in South Africa is not in the lower band. While lower rates are designed to stimulate borrowing and spending, the actual outcomes depend heavily on how investors and consumers react.
On one hand, lower rates offer opportunities in the equity market and relief for indebted consumers. On the other, they squeeze the profitability of banks, make bonds less attractive, and can prompt unexpected changes in savings behaviour.
For South African investors, the rate cut is sure to offer both challenges and opportunities. Understanding how these dynamics interact will be key to making informed decisions in this new economic landscape.
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Sources :
*South African Reserve Bank (SARB), 2024. Statement of the Monetary Policy Committee: September 2024.
**Source: Borio, C. and Gambacorta, L., 2017. Monetary policy and bank lending in a low interest rate environment: diminishing effectiveness? Journal of Macroeconomics, 54, pp.217-231.
Federal Reserve Bank of Chicago, 2014. Monetary policy and low long-term interest rates. Chicago Fed Letter No. 324, July.
Russell Investments, 2023. How low interest rates impact investors.
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