What do higher interest rates mean for the Aussie share market?

The Reserve Bank of Australia has begun unwinding its pandemic-era interest rate cuts, leading many to wonder what this will mean for households, businesses and, of course, shares.

The fact that rates are rising from such a low base — and alongside an improving economy — should give investors comfort, but some uncertainty is sure to persist. Below, we take a look at what higher interest rates might mean for Aussie shares.

First, how do interest rates affect the economy?

When the RBA raises or lowers the cash rate, it has immediate effects on many of the moving parts of the economy, either directly (such as by increasing or decreasing the cost of doing business) or simply by shifting the economic mood.

Lower interest rates make servicing debt more manageable, which is why cuts to the cash rate are usually followed by a mad rush to buy property. 

At the same time, businesses will be more inclined to borrow money to buy inventory and hire new staff, which in turn affects the level of employment and inflation in an economy. 

If, however, the RBA decides to raise interest rates, it will immediately translate to higher borrowing costs for both households and businesses. 

As a greater chunk of Australians’ income is eaten up by debt repayments, less is left over to spend as they please. This drop in demand lowers businesses' revenue and profits, impacting their ability to hire and reinvest.

So what can we expect from the share market?

We might intuitively expect shares to fall as rates rise — after all, much of economic growth is fuelled by debt, and as businesses’ borrowing costs increase, opportunities for growth narrow. 

But the relationship between interest rates and the share market isn’t so clear cut, and for all the times shares dipped during a tightening cycle, we can find just as many times where they rose.

AMP chief economist Shane Oliver recently poured water on the idea that higher interest rates alone will tank Aussie shares, arguing that rising rates typically only spell trouble if they go beyond “normal” levels.

“They are also a problem when rate hikes are aggressive, as in 1994 when the cash rate was increased from 4.75% to 7.5% in four months,” he said.

There’s also the matter of savings account rates, which aren't so attractive at the moment. Though they’re set to rise soon, Oliver is betting that many Australians will still prefer the comparatively higher returns offered by the share market.

“If the RBA cash rate rises to 1.5% by year end, deposit rates would still be less than 2%, so they will still be low relative to the grossed-up dividend yield on shares of around 5.5% leaving shares relatively attractive,” he said.

Lastly, the Aussie share market tends to move in line with the US share market, so conditions in the US could wind up being more meaningful than any domestic interest rate movements.

“Given the high short term correlation between Australian shares and US shares, what the Fed does is arguably far more important than local interest rates, and this is perhaps a bigger risk given higher inflation in the US,” he said. 

So higher interest rates aren’t necessarily a guarantee of lower returns on shares. Rather, it’s necessary to look at the broader context in which rates are going up, and right now the overall picture is one of high volatility.

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