“The world is changed. I feel it in the water. I feel it in the earth. I smell it in the air. Much that once was is lost, for none now live who remember it.”
– Galadriel, The Fellowship of the Ring [1]
Remember the days when we’d forgotten inflation existed? When earning money on cash was just a hazy memory of building society passbooks and logging into first-generation Internet savings accounts?
Yes I know that world was just three years ago. No need for Peter Jackson’s FX wizardry to bring 2021 to life. I’ve still got a jar of curry paste at the back of my fridge from then that needs finishing.
And yet… some people are talking [2] like the environment has changed forever.
Rates and yields are up and will stay that way. Cash is king, bonds are bullshit – and don’t talk to me about mortgage rates.
If that’s you, then buckle up!
US inflation is falling faster than expected [3] – after nearly a year of false dawns – and the Federal Reserve will begin to cut rates soon. Almost certainly in September I reckon, especially after its latest minutes cited the Fed’s political independence. That preemptive reminder smacks to me of starting a rate hiking cycle on the cusp of the US elections.
Back home UK inflation is already on target [4] at 2%. Yes, some price pressure remains – particularly in services – but I don’t believe that’ll stop the Bank of England cutting. Probably in August.
It’s got a green light now the Fed looks like it’s sharpening its axe. And the ECB has already done [5] its first interest rate cut for five years.
Rate expectations
What will happen when the all-important US Federal Reserve starts cutting interest rates?
Well, this is investing and you know the score…
…it depends!
One or two cuts won’t change much. In theory they should be more or less priced-in.
The ructions we saw over the last couple of years as rates soared were because they went much higher – and more quickly – than investors expected, as inflation proved stickier than was anticipated:
[6]Source: Bank of England [7]
I warned rising interest rates [8] would have ramifications in February 2022. Just a few months later I was urging you to stress test [9] your mortgage payments.
Good stuff and I’d argue I was modestly ahead of most commentators out there. Many Monevator readers also shrugged at the idea of rates rising. Nothing to see here!
Which was fair enough really, because I certainly wasn’t screaming about the bond crash [10] we actually saw in 2022.
Nor did I predict, obviously, the turbo-charging factor of somebody thinking it’d be a good idea to hand Liz Truss [11] the levers of power for a few weeks that year.
In fact if you weren’t humbled by how inflation, rates, bonds, and equities moved between 2022 and 2024 then you either weren’t paying attention, or else you earn seven-figures at an investment bank, got it all wrong too, but you’re not paid for feeling humble.
What goes up can come down
Anyway here we are on the cusp of rate changes once more. Things shouldn’t be as dramatic as exiting the near-zero rate era, however.
Inflation looks mostly tamed, barring unforeseen ‘events’. Rates will be cut – and the Fed in particular usually keeps cutting for a while once it gets started.
But I don’t think we should expect US rates to fall much below 3% in the foreseeable future, from 5.5%.
UK rates may well not get much lower than 4%, from today’s 5.25%.
What do I know, though? In fact what does anyone know?
Well, the shape of the yield curve does give us a clue that rates aren’t expected to head much below 4%. In fact it suggests they’ll need to rise again in a few years:
[12]Source: Bank of England [13]
However long-term rates aren’t under a central bank’s control. Yes its short-term rate stance influences expectations. But a bunch of other macroeconomic variables are more influential.
Besides, as always anything can happen.
The graph above charts forward yields for the next 40 years. But five years is a long time in the markets these days. Five months sometimes.
So with all these offerings to the anti-hubris forces duly tossed onto the sacrificial altar of prevarication, let’s consider how a few rate cuts could shake things up.
Interest on cash savings
We could have a big debate about whether central banks set interest rates or whether they basically follow market rates, which in turn are largely driven by inflation and economic prospects.
I’m inclined to think a bit of both, especially since quantitative easing arrived. But there’s no denying that at the sharpest end for commercial banks, central bank policy rates are strongly influential.
Long story short: once the Bank of England starts cutting rates and likely beforehand – basically right now – the best rate you’ll get on easy-access cash will fall. (Bonuses, teasers, and gimmicks aside).
We’ll probably have a grace period where we can lock in higher rates on longer-term savings though. And as always when to fix will be a guessing game.
It’s probably futile to try too hard to outwit the money markets. Spend your energy instead hunting for the best rates that suit your time horizon whenever you actually have the cash to hand.
Whatever you do don’t leave cash languishing in low-rate current accounts for years! Even with inflation [14] back to normal levels.
Mortgage rates and house prices
Sitting right alongside cash savings in another in-tray marked No Shit Sherlock are mortgage rates.
Yes, mortgage rates are determined by market swap rates [15], not the Bank of England’s Bank Rate.
And also yes, if the Bank of England is cutting interest rates then it will very likely to be doing so in an environment where yields – including swap rates – are softening across the waterfront.
But whatever the drivers, mortgage rates will probably fall as Bank Rate falls, at least a bit.
That lower mortgage rates are coming is suggested by the BOE’s forward curve for overnight swaps:
[16]Source: Bank of England [13], yesterday.
Five-year fixed-rate mortgages have already sported lower rates than two-year fixes for some time. (Usually you’d expect longer fixes to be pricier, due to inflation and interest rate risk, and various market forces.)
How far could mortgage rates fall when the rate cutting begins? That remains to be seen.
Much of it will already be priced in, as per the yield curve above.
I’d love the chance to fix my mortgage for five years at 2% again. But I don’t fancy my chances.
Back to buy-to-let?
When mortgage rates spiked in 2022, it revealed just how stretched house prices had become. Particularly in London, the South East, and certain other hotspots around the country.
Together with tax changes finally reaching their apogee, higher rates also ruined the economics [17] for sensible buy-to-let landlords.
But if mortgage rates fall a lot, then the opposite could be true.
Housing will become more attractive again, and prices will rise. Landlords will resume their bidding against first-time buyers.
I’m not saying it’s right or desirable for house prices to rise like this. And I suppose if Labour really does encourage 1.5 million new homes to be built then this could dampen things.
At the same time though, building on this scale will require loads more well-paid bricklayers, electricians, plumbers, and so on. And they’ll all want somewhere to live…
Bonds
Central bank interest rate decisions do not control bond yields. They are only directly influential at the very short end, where overnight cash and cash-like securities compete with the lowest duration bonds.
However even this limited effect does influence yields along the curve, to some extent.
More importantly, interest rate moves are usually reflective of how market rates are moving anyway.
I mean we all saw how the interest rate hikes of 2022 to 2023 coincided with the smashing of the bond market.
But if you weren’t paying attention, here’s a reminder, with reference to iShares’ core UK gilt ETF (ticker: IGLT):
[18]Source: Google Finance [19]
Quite the speedy crash to suffer in anything you hold a lot of – let alone what most people considered to be the safety-first bulwark of their portfolio.
We’ve written a lot about why this happened [10] and what it means. (And also whether we should invest differently [20] with these lessons learned going forward).
And my co-blogger The Accumulator has also written extensively [21] about how and why bonds of particular ‘duration’ respond to changes in yields.
Check out our bond archives [22] for a refresher.
The point I’m here to make today though is that the same maths that drove bond prices down when yields rose as inflation ran rampant will do the opposite if yields go into reverse.
Bond duration maths doesn’t just tell us how much bonds will fall with lower yields. It also tells us how they will rise.
Again, I’m not going to repeat all our previous articles here. Suffice it to say that with an effective duration of around 8, the iShares ETF above could see a return (with income) of over 20% if its (constituents’) yield was to fall by a couple of percent due to prolonged interest rate cutting.
Now as it happens, I do not expect yields to fall by 2% across the board for gilts.
And the crash in the graph above reflects a historic move from near-zero to 4-5%. The reverse isn’t likely to be repeated.
But some kind of notable capital gain is likely if and when rates move down and stay down, presuming inflation remains subdued. That’s the main point to takeaway.
Do you feel lucky, punk?
Indeed there are opportunities to get quite cute with bonds if you’re that way inclined.
A friend of mine has put a big wodge of his portfolio into one of the longest-dated UK gilts – an issue not due to mature until the 2060s. From memory the duration is around 20 or more.
And in doing so he also secured a yield-to-maturity of over 4%.
As my friend sees it, he’s locked in that 4% for the rest of his investing life assuming he holds until maturity. But he also effectively gets an ‘option’ on an economic depression until then.
His very long duration gilt would soar if rates were ever slashed back towards zero. And that could offset a lot of pain in his portfolio elsewhere in such circumstances.
On the other hand his holding will go down 20% if yields rise by just 1%. Not for widows and orphans!
For most Monevator readers the point is that it’s probably a bad time to throw gilts overboard.
Yes it would have been great not to own them in 2022 and 2023, with hindsight.
But that was then, this is now. Going forward government bonds offer a small but reasonable yield, as well as the potential to cushion your equity portfolio in a conventional tits-up stock market crash.
That’s not to be lightly discarded, unless perhaps you’re in your 20s or early 30s with many decades of saving and investing still ahead of you.
Equities
The $100 trillion question! How will equities perform when rates are cut?
In theory lower rates should be good for most companies.
This is partly for practical business reasons – debt becomes less costly to service, and growth capital is easier to source – but also theoretical.
Rate cuts could lead to analysts using a lower discount rate in their valuation sums. This mathematically boosts the potential value of future earnings, and hence the perceived ‘fair value’ of share prices.
Even firms that have benefited directly from the higher rate environment – High Street banks, say – could benefit if easier money staves off the threat of rising delinquencies in their loan books.
Remembering the fallen
Some companies will do better than others, of course. And to the practical and theoretical drivers behind any such divergence we can also add market sentiment and animal spirits.
In theory, investors should have been ‘looking through’ the past couple of years of higher rates when they valued biotech growth stocks, say, or the holdings of specialist investment trusts.
Most of these assets are expected to be around for decades, if not indefinitely, after all.
High rates will cause the odd car crash, sure. What really matters for most investments when it comes to rates though is their level (and that of inflation) over the business cycle – or even the life of the company.
But in practice, traders gonna trade.
For instance, infrastructure and renewable energy trusts went from sky-high premiums of 20% or more just a couple of years ago – before rates rose – to discounts of about the same level at their recent lows.
That’s a 40% move in valuation versus net assets – effectively driven by vibes, not fundamentals.
Who says this won’t be at least partially reversed if rates fall a lot?
Yields on such trusts could start to look comparatively tempting again. Wealth managers with one eye on career risk might finally decide it’s safe to put them in clients’ portfolios once more.
Similar arguments can be made for small cap stocks and disruptive technology (outside of AI).
In fact most shares that had the misfortune during the last couple of years to not be US large caps touting a compelling AI story could have some legs in them.
Back out recent gains from the so-called Magnificent Seven [23] and a few other AI-related plays – and perhaps the weight loss drug giants of Europe – and US and global returns would be much more muted.
However if input costs are now no longer going up and rates are coming down, then many companies around the world could look better value on paper than those tech giants. Barring an everything-changes AI singularity, anyway.
The subsequent market rotation away from mega-cap growth could fuel a broader rally for such stocks.
I just read [24] that nVidia fell 5% with the US inflation surprise yesterday. At the same time US small caps spiked 3% higher. Early moves aren’t always right, but it’s pretty suggestive.
Or something weird could happen and the global stock market could crash 30%.
Because that could always happen. Never forget it.
Annuities
I’m no expert on annuities [25]. However all things being equal I’d expect a lower interest rate environment to reduce the annual income you’re offered in exchange for your pension pot.
Annuity amounts have soared [26] since the lows of December 2021. We’re talking payout rates 30% to 80% or more higher now than back then, depending on your age and what annuity you went for.
That is a gigantic move for a payment that is fixed for life. A 60-year old might have been promised a little over £4,000 every year for a level rate annuity in late 2021.
Today they’d get over £6,000 annually for life for the same £100,000.
As stated, I doubt we’ll see interest rates near-0% again (though never say never [27]). But yields across the market will likely come down to some extent. And it usually pays not to be too greedy.
Irreversibly swapping capital for an annuity is a terrifying prospect for me. But it may be the simplest and best thing to do to secure an income in many circumstances, at least with some portion [28] of one’s capital.
Stay alert, and seek advice if you need it for sure.
To conclude at the beginning
To repeat myself, nobody knows with certainty the forward path of interest rates.
It’s true people are paid millions to put other people’s billions behind their views of where rates will go.
And various yield curves give us a clue as to how these bets are shaping up, too.
But none of this future is nailed-on, and such predictions are frequently confounded. Again, compare market expectations for rates in late 2021 with where we were by mid-2023 for a textbook example.
If rates fall a lot, then it would be very good for bonds and potentially for equities.
As I say, many people have a ‘cash is king [29]‘ attitude at the moment. It usually takes a few years of big gains from markets and titchy returns from cash accounts to change that.
On the other hand, starting valuations for equities are far from on the floor. The US already looks positively peaky [30]. We’d need to see earnings really take off for US markets to keep pulling ahead.
A lot will depend on why rates are cut – if they do fall very low – as much as the absolute level they reach. And again, how much the pace of rate cuts and the level they settle at comes as a surprise to markets.
If rates go down because inflation is quiescent despite a strong global economy then we’re golden.
But if rates are ultimately slashed in the face of a big slowdown and rising unemployment, then that would be much better for bonds than for most equities.
As ever, a typical person will do best to diversify their portfolios passively [31] and try not to be too cunning.
But as always, others [32] of us will ask where’s the fun in that?
Either way we’ll be here on Monevator throughout the cycle – trying not to humblebrag too much when our warnings prove prescient whilst guiltily disclaiming our human failings.
TLDR: maybe it’s a good time to lock-in a high rate on your cash on deposit, but also to be a bit more optimistic if you’re remortgaging.