What’s next for global interest rates in 2024?

Central banks have become increasingly data dependent in their decision making. Yet the big shifts in monetary policy are often due to surprise events.

Last week the Bank of England cut interest rates to 5%, the US Federal Reserve (Fed) held steady and the Bank of Japan raised rates.

So, what do interest rate moves mean for investors?

Interest rate hikes and cuts matter. When rates fall, bond prices typically rise. This is because investors will earn less on newer bonds with lower coupons, encouraging investors to buy the bonds already in issue at a higher price.

Lower rates are also positive for shares. Future earnings are discounted at a lower rate, boosting their current value. Companies borrowing costs fall too. And lower rates are positive for the economic outlook – and therefore future earnings growth.

Data dependent decisions

For investors, knowing what data central bankers are focused on can help them understand – and even anticipate – rate changes.

However, data is backward looking and takes time to collate. Therefore, central banks must make decisions based on information that’s already out of date. This makes it more likely that they’ll be slow to react.

Inflation in the Eurozone fell into negative territory in 2020 at the start of the pandemic. The central bank and governments reacted to the crisis by easing monetary policy and boosting spending. But these policies, combined with supply bottlenecks caused by the shutdown, triggered a sharp rise in prices.

Inflation exceeded the European Central Bank’s (ECB) 2% target in July 2021, doubled to over 4% by October, and doubled again to over 8% in May 2022.

Yet the ECB first raised rates in July 2022, from -0.5% to 0%. Rates were raised 10 more times, taking the rate to 4.5% in September 2023. Meanwhile, inflation peaked at 10.6% in October 2022 and is now 2.6%, marginally above the target level.

The point of this example isn’t to say that there was a policy error. The pandemic-led shutdown and re-opening of the global economy was impossible to model. In fact, economists were telling us that policy was too tight or too restrictive over this period.

Instead, we’re highlighting that there was no obvious link between the most important datapoint for the ECB – the inflation rate – and its policy decisions. The big rise in rates was driven by a surprise increase in consumer prices – not evident in any backward-looking data.

What drives interest rates?

In practice, the big shifts in central bank rates over the last generation have mostly been driven by the unexpected – the bursting of the dotcom bubble, the global financial crisis and the recent inflation spike.

The dotcom bubble burst in March 2001 and a recession followed. The US Federal Reserve funds rate was 5% at the time and was cut incrementally down to 1% by June 2003.

In 2007 problems emerged in the US sub-prime mortgage market. This triggered a tightening of financial conditions around the globe that led to the failure of Northern Rock in the UK – and the collapse of Lehman Brothers a year later which was the landmark event in the global financial crisis. The US Fed funds rate was cut from 5.25% in August 2007 incrementally down to 0.125% in December 2008.

The recent inflation crisis has seen a similar magnitude of change, but in the opposite direction.

The US Fed funds rate was raised from 0.125% in January 2022 to its current level of between 5.25% - 5.50% in July 2023.

The only exception to this crisis-led response was during the economic recovery from the technology bubble. The US Fed raised rates by a quarter percent at every meeting between May 2004 and June 2006.

We could argue that this gradual approach reduced the perceived risks for borrowers – and helped sustain the US housing bubble that led to the sub-prime crisis.

When words matter

Investors are forward looking, anticipating future rate changes by central banks. When rate announcements are in line with expectations, stocks and bonds tend to move little.

This also means that words alone can be enough to move markets.

In December 2023, the Fed pivoted its messaging from fighting inflation to signalling that rate cuts were coming.

The market reacted by pricing in seven rate cuts in 2024 – this despite the Fed projecting just three.

Stock and bond prices rose, pushing down borrowing costs. And this easing of financial conditions has helped sustain steady growth in the US economy. This resilient economic performance has delayed the first cut in rates well beyond that expected immediately after the pivot.

Thinking in scenarios

Many market watchers are busy analysing last week’s decisions from the US Fed and the Bank of England.

At the time of writing, the market is pricing just over a 50% chance of three cuts in the US between now and the end of the year. But for long-term investors, the exact timing and number of rate moves over the near term is largely irrelevant.

Instead, we encourage investors to think about possible scenarios over the longer term.

At one extreme, we could see a return to the pre-pandemic environment.

In this scenario, a combination of continued slow productivity gains, an ageing population and effective inflation targeting by central banks keeps inflation low and sees rates fall back towards zero.

Government bonds would be expected to perform well in this scenario – of course there are never any guarantees though.

At the other end of the spectrum, the fall in the working age population as a percentage of the total puts upward pressure on wages.

Deglobalisation makes it harder to source cheaper goods and services from abroad.

High debt servicing costs also make it challenging for central banks to raise rates sufficiently to bring core inflation – and inflation expectations – back to target levels. This pushes inflation higher and central banks are eventually forced to raise rates above current levels.

Bonds and stocks would be expected to suffer in this environment, with real assets like gold and commodities offering potential shelter. This too is unlikely as it implies that central banks are largely ignoring their inflation-targeting mandate.

Investors need to be prepared

Forecasting economic outcomes is hard. The old joke goes that economists have forecast nine of the last five recessions. Turning these forecasts into reliable market predictions is even harder.

A third scenario, and in my view the most likely outcome, is somewhere between the two extremes described above.

This outcome would see rates come down, but settle well above the levels of the decade before the pandemic.

Whatever happens to rates next, investors will be better prepared if they understand the risks to their portfolios if interest rates surprise in either direction – it’s important to have a diversified portfolio so you have something performing in all scenarios.

This article isn’t personal advice. Investments and income from them can rise and fall in value, so you could get back less than you invest. If you’re not sure if an investment is right for you, ask for financial advice.