When most people hear the term ''interest rates'', they think of the official cash rate (consciously or otherwise). This rate is set by the Reserve Bank board each month and is important because it impacts the cost of short-term finance, including the rates charged on variable rate mortgages.
The official cash rate is used as both an economic accelerator and handbrake by the Reserve Bank. When economic conditions turn down, as they have over the past 18 months, lower cash rates stimulate economic activity. When the Reserve Bank board believes things are heating up, it raises rates to slow them down; as it has done at its past two monthly meetings.
It's important to be aware of the official cash rate but there's another rate that should have as big a bearing on your sharemarket investment decisions as the official cash rate does on your mortgage: the 10-year government bond rate. There are several reasons why this is an important rate.
Firstly, it's a decent guide to future movements in short term rates. In January, buyers of 10-year government bonds were locking in a return of less than 4% for the coming decade. By June, that figure had risen to 5.8%; to anyone tracking this key measure, recent rises in the official cash rate would have come as no surprise.
Another reason why the 10-year bond rate is important is that it is typically viewed as an investor's ''opportunity cost''.
As a long term investor, by buying a 10-year government bond you can currently lock in a return of a little over 5.6% for the coming decade.
As it essentially involves lending money to the Federal Government, the 10-year bond rate is often referred to as the ''risk free interest rate''.
So, to take on the considerable risk of investing your money in shares, you need to be confident of an average annual return well in excess of this risk-free rate. In this way the 10-year bond rate exerts a ''gravitational pull'' on sharemarket returns; the higher the bond rate, the less a prospective investor will be inclined to pay for shares.
That's because our hypothetical investor will demand a higher return from the sharemarket to lure them away from the safety of government bonds. And, using this frame of reference, we can intuit a few things about the relative value between the sharemarket and the bond market.
Back in January, as the sharemarket was approaching a low point, the 10-year bond rate sank below 4%. This meant the gravitational pull on share prices was very weak by historical standards; bonds weren't offering much return compared with the dividend yields provided by a portfolio of blue chip shares.
Since January, the equation for share investors has become more treacherous; the 10-year bond rate has surged to 5.6% at the same time as share prices have risen strongly. In other words, 10-year bonds look more attractive than they did in January, while stocks look less so after having already risen by so much.
Capital growth eyed
Buying a portfolio of Australia's top blue chip stocks will likely provide a dividend return of less than 3.5% over the coming year. So today's buyer is counting on a decent amount of capital growth to ensure they're ahead of the safe-and-sound government bond investor, at the same time as shares have already delivered remarkable returns from their low point.
It's not impossible that the sharemarket will rise strongly from here, but it's much less likely to do so than it was back in January. Interestingly, though, while short term rates were nudged up this week by the Reserve Bank, the 10-year bond rate has eased a little over the past fortnight - from 5.8% to 5.65%.
This has occurred in tandem with the past fortnight's sharemarket hiccup. And if both of these trends continue (lower bond rates and a falling stockmarket), then the equation for sharemarket investors will improve once more.
Our analysts would rarely let broad financial or economic factors stop them buying a good share at a sensible price.
But it's all part of the backdrop we consider when going about our daily search for sharemarket bargains and provides some useful food for thought.
