RBA Rate Cut and Banking Profitability in Australia

In the past we see rate cut cycles being positive for stock markets as they signal an impending positive.  But there are a few reasons to be watching carefully right now. 

Rates are so low at 1.25% – there isn’t a lot of room to move if we get into real trouble.  We are now heavily indebted as individuals and as a country therefore more exposed to any shocks in the global system because we are without the get out of goal free card we had in 2008.

Additionally, there is a point at which banks won’t pass on RBA cuts – and we are dangerously close to it. The business of banking is relatively simple.  Banks borrow funds from depositors and lend to borrowers.  Currently the payment to depositors is meagre – almost unable to be lowered any further.  Whilst the world flouted with negative interest rates a few times since 2008, I don’t think people will pay to have their money in the bank!  In other words deposit rates cant be lowered too much more. 

If banks want to protect their margin (and they do) there isn’t room to pass on rate cuts at infinitum.  This means that the RBA can lower rates as often as they like but their effect won’t have the desired effect.  The big banks (ANZ, CBA, NAB and WBC) will have it easier than the smaller banks (BOQ, BEN etc). It won’t matter how loud the Treasurer shouts it!

Where rate reductions don’t get passed to consumers the RBAs aim of reducing unemployment and increasing inflation has little hope of success.  The multiplier effect appears to be limited from here on.  Monetary policy is a blunt instrument – soon it could be an ineffective instrument.

Does all of this make the share market more interesting?  Cautiously, yes.  With the right strategy, even a modest dividend with franking credits beats the deposit rate.  Unfortunately, most people look to banks for big dividends and structural growth.  In reality, there has been little growth in share prices of the banks for many years – so we are left with dividends.  If our thesis is correct then bank profits are going to come under more pressure, meaning their dividends will be under pressure. Owning banks for capital growth has been disappointing.  With dividends under pressure, there is little reason to be excited about placing money in this sector. 

If you must invest in banks, there will be a chance to trade them – which is what Pythagoras does by using maths to trades the cycles within share prices, again and again.  Buying in the fear and selling when greed returns.  Outside the banks there is always opportunity to do the same.

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Michael Dee, 0419726223

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