Cuts to interest rates are a key financial news theme in 2024 and we don't expect that to change in 2025. Many central banks across the world are looking to reduce interest rates as inflation figures slowly return to normal. It is often heralded as great news for mortgage borrowers, but what about investors?
Financial markets love predictions, and interest rate cuts or hikes are often predicted well in advance. Significant investment decisions are often made months before a change on the basis of those predictions. This is often described as something being 'priced in' to investment markets. For example, November’s US election result is probably already 'priced in' to US equity markets because people have made investment decisions in anticipation of the result.
As a result, changes in interest rate expectations tend to have a big impact. As the US equity and bond markets are the largest in the world, any anticipated change to interest rate expectations tend to matter the most. That's why you hear so much talk about what the Fed will do next.
Interest rates and bonds
Bonds are loans issued by governments or companies which pay a fixed amount of interest, with your capital back at the end of the term.
Bonds usually perform well when interest rates are falling. In this environment, the interest (or ‘yield’) from existing bonds looks more attractive compared to new bonds that offer less interest. Typically, this makes the price of existing bonds go up.
When interest rates are rising, investors will often demand higher rates from bonds given what they can get elsewhere. As the interest paid by bonds is fixed, the only way for this to happen is for the price of bonds to fall.
So, when bond prices fall yields rise, and when prices rise yields fall. That's what most investors expect to happen, and they will take a view in advance on how attractive bonds are based on an expectation of what will happen to interest rates. This is how interest rate expectations can influence bond prices in advance of any change happening.
Interest rates and shares
Shares aren’t directly affected by interest rate changes, but they can be sensitive to them as falling interest rates should be good news for businesses and in turn good for their share prices. The lower the interest rate the cheaper it is for a company borrowing money. Borrowing helps growth and in turn boosts earnings. As most businesses have something to sell, lower mortgage rates puts more disposable income into their customers pockets. Higher consumption is good for business, and share prices, as they sell more goods and services.
The opposite is true with high interest rates. Borrowing, and consequently growth, contracts when people buy less.
This general rule is more pronounced in certain sectors. The technology sector, which has experienced huge growth in recent years, is attractive to investors based on what their future earnings might be rather than what their profits are now.
A major attraction of tech companies is the chance for higher earnings in the future compared to what they earn now. In a low interest environment investors can't earn as much from cash or bonds so this type of equity investment might look more appealing than usual.
The banking sector is much more likely to benefit from higher interest rates. Banks can earn more from the interest they charge on loans than the interest they pay on cash savings.
So, is an interest rate cut good news?
As you can see it's not as straightforward an answer as you might think. Different sectors perform differently depending on the conditions which is why we always recommend a diverse portfolio for our clients. Diversification spreads the risk of a wide number of factors, including interest rates, across a number of different sectors and countries. This means you shouldn't be putting all your eggs in one basket.
We can all recognise that high interest rates which put a lot of people under financial pressure aren't good for the country and that means they aren't good for anyone in the longer term.
It's also important to acknowledge that the context of an interest change is also important. We've seen cuts recently as a result of positive news about inflation. We've also seen rates cut when Covid-19 threatened to wipe out the economy.
This article is for informational purposes only, this should not be taken as advice. Past performance is not a guide to future performance, nor a reliable indicator of future results or performance.
The value of units can fall as well as rise, and you may not get back all of your original investment.
