Maintain or Reduce Cash Holdings?

Australian interest rates seem likely to fall further this year.

Does this mean investors should reduce their asset allocation to cash and fixed income?

Falling Interest Rates

In February, the Reserve Bank of Australia cut the cash rate by 25bps. In doing so, they shifted people's expectations about the future path of interest rates, which are now expected to fall further and remain lower for longer. Indeed, many other central banks have unexpectedly lowered rates over the past few months, including that of Canada, China, India, South Korea and Switzerland. This renewed global monetary easing is designed to support growth and boost inflation.

Where to Invest?

As interest rates fall yet again, it leaves many Australian investors with a dilemma about where to invest their savings.

Typically, investors hold a portion of their portfolio in defensive assets including cash or fixed income, as a way to earn a steady income stream. But unfortunately, this income is compressed each time rates drop, prompting many to shift into more risky, higher yielding investments. As a result, the valuation on these assets have climbed and risk premiums have compressed, which means that investors are less likely to be well compensated for bearing additional risk. So it may no longer be worthwhile to chase high yield investment.

Interest Rate Linked Assets

Investors who are tempted to deviate from their strategic set allocation may want to revisit their long term investment goals. An investor, for example with only a moderate tolerance for risk, should consider why they would be willing to take on more risk simply because interest rates are lower. In the event of a market down turn, this type of investor may be more inclined to panic and sell investments at the worst possible time, which defeats the purpose of chasing yield in the first place.

This brings us back to the key reason to hold defensive, interest rate-linked assets in a provide diversification benefits, a stable income stream, and an anchor during times of market stress. These characteristics endure regardless of the level of interest rates.