By now most investors will have heard the news that the Reserve Bank of Australia (RBA) has decided to reduce the cash rate from 2.5% to 2.25%.
It's also no coincidence that at 2:30 pm yesterday the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) leapt higher on the news of the RBA's decision. In fact, by the end of Tuesday's trading session the index had gained a whopping 1.4% to close at a fresh six-and-a-half-year high of 5,707.
Amongst the blue-chips leading the gainers were telco giant Telstra Corporation Ltd (ASX: TLS) which added a massive 2.1% for the day to close at an 11-year high of $6.67. Meanwhile, Australia's largest bank Commonwealth Bank of Australia (ASX: CBA) touched a new all-time high of $90.67 with many investors wondering how long before it cracks the $100 mark.
There are at least two explanations as to why these two blue-chips and many others rallied on the news of an interest rate cut.
Yield play – with official interest rates at record lows, the demand for dependable fully franked high yielding stocks has arguably never been greater, particularly by self-funded retirees and self-managed super funds (SMSF). Telstra, Woolworths Limited (ASX: WOW) and bank shares have been amongst the biggest beneficiaries from this chase for yield.
Valuation – it might appear that there are many different techniques employed to value an asset such as equities and in one sense that is true. However, in reality, the risk-free interest rate is an integral factor in determining value no matter what technique is used. Because an asset is valued with reference to the risk-free interest rate (it forms part of the denominator), a lower rate (all other things held constant) leads to a higher valuation.
The big question for investors now, as we continue to sail into uncharted waters, is whether this ultra-low risk free rate leads to an accurate valuation or not…
