For most people today’s news that Australia has lifted it’s key short-term interest rate for a 3rd-straight month is of no importance. After all, you probably don’t hold any Australian deposits or aggressively speculate in foreign currencies.
However, if you’re shopping for a home or considering a refinance this morning’s headline is more news worthy than you think because interest rates abroad can impact interest rates here in the US. Here’s how….
Investors with money to lend are constantly looking to obtain the highest yield with the lowest risk. In today’s global financial marketplace they have more options than ever before. When interest rates change it also changes the relative competitiveness of investment opportunities and therefore causes a shift in demand a country’s fixed income investments. When demand for a country’s fixed income investments increases it drives their interest rates lower and vice versa.
For example, let’s say that yesterday XYZ hedge fund had $1 million dollars that they wanted to place in short-term deposits. As of yesterday they could deposit that money in a US-denominated overnight account and receive a small rate of return of 0-.25% based on our Federal Funds rate. However, had they deposited that money in an Australian account they could have earned a 3.5% return. Because of perceived currency risk or other factors they decide to stick with the US deposits earning a more modest return.
This morning ABC hedge fund is in a similar situation with $1 million to park in a short-term deposit vehicle. They are now comparing the opportunity of US-denominated deposits at 0-.25% or Australian deposits at 3.75% (an extra .25% higher than yesterday). They decide to deposit their money in an Australian account because the additional .25% of return is enough to overcome other risk factors under consideration. As a result, it drives demand for Australian-denominated investments higher and interest rates lower while in the US it pulls money out of the domestic investment marketplace pushing interest rates higher.
My guess is over the next few months other economies around the world who were less impacted by the global credit crisis and more dependent on commodities (i.e. oil & metals) to make their economy run will follow Australia’s lead in raising short-term rates. Little by little this will put upward pressure on interest rates here at home.