What’s next for interest rates and what does it mean for stock markets?

The US Federal Reserve (Fed), the Bank of England (BoE) and the European Central Bank (ECB) have all now cut interest rates.

The Fed’s first cut of 0.5% was bigger than the equivalent cuts by the ECB and the BoE. However, as the ECB has cut rates twice, both central banks have cut by 0.5% in total. The BoE chose to hold rates steady in September, meaning it’s cut by 0.25% so far.

After a period of rising rates and then stable, relatively high rates, this is the natural next step.

But, what’s next for rates?

How far could they fall and how quickly are the two key questions on investors’ minds.

This isn’t personal advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invested. Past performance isn’t a guide to future returns. If you’re not sure an investment is right for you, ask for financial advice.

What’s the Federal Reserve saying?

They expect US rates to come down further in 2024, probably by another 0.5%.

Looking further out to the end of 2025, they’re expecting a further 1% of cuts, taking the base rate to somewhere in the region of 3-3.5%.

There’s some variation in expectations between members of the Fed though, with one individual predicting rates will still be around 4% at the end of 2025.

This shows that predicting where rates will go over longer time frames is difficult as there are lots of things that can impact potential future changes.

How about the Bank of England?

While the Monetary Policy Committee (MPC) – who decide interest rates for the BoE – didn’t cut for a second time in September, Andrew Bailey, Governor of the BoE, was clear that further rate cuts were likely in future.

He also noted a desire to reduce rates gradually over time. This makes it more likely that they will implement further 0.25% cuts over time, rather than bigger reductions like the 0.5% one made by the Fed.

In the UK, all eyes now turn to the next meeting of the MPC in November – as things stand, a rate cut is expected.

What could change things?

Things that could keep rates higher for longer:

• Inflation is a key risk. If it comes back higher than expected, then it’s possible the speed of any future rate cuts will be slower.

• Similarly, if economic data is stronger than expected, this would increase the potential for inflation to rise again and so would likely mean slower rate cuts.

• Changes to government spending, known as fiscal policy. With the first Autumn Budget from the UK’s new government due in October and the US going to the polls in November, it’s possible that government spending might increase. This could in turn cause economic strength or higher inflation, which would impact interest rate decisions.

Things that could push rates lower more quickly:

• A recession. This would likely mean either bigger rate cuts or more of them. Many economists have been expecting the rate rising cycle to cause a recession based on history. So far this hasn’t happened, but with rates still above long-term expectations, this remains a risk in future.

• An unknown market shock. There’s always the risk of an unpredictable shock that could cause rates to rise or fall significantly. The pandemic is a recent example.

Overall, with inflation relatively stable, there’s little reason to believe that central banks won’t continue to reduce rates steadily from here.

What does this mean for investing?

Markets move quickly. And often in anticipation of upcoming events, based on their best guess of what might happen.

For example, the Fed’s 0.5% cut. On the day of the announcement, the US stock market ended 0.3% lower and the interest rate sensitive 2-year Treasury yield fell by just 0.02%. These are not the moves of a market reacting to new information. Investors expected a 0.5% cut.

Arguably therefore, to make the most of rate cuts, investment portfolios need to be adjusted in advance.

This is true to an extent and perhaps best shown by the performance of bonds in recent months. Bonds are particularly sensitive to interest rates and so changes to interest rate expectations can impact bond prices quite a lot.

Bonds therefore returned, roughly, between two and three times their average over the three months to the end of August. And the final column shows how rare it is that these sectors have three-month returns at this level or higher. They’ve continued positively in September too.

However, just because they’ve performed strongly, doesn’t mean that they won’t continue to perform well or that investors have missed the opportunity. But clearly three months is a very short time period to consider when investing and past performance isn’t a guide to future returns.

With yields still higher today than they were for most of the 2010’s, and the potential for further rate cuts seemingly high, we think it’s still a good entry point for bonds.

In terms of shares, it’s harder to have a firm view.

Shares can perform differently during rate cutting cycles because it’s often more relevant why rates are being cut. If rates are being cut because of a recession, it’s likely that the impact of the recession itself will have a greater impact on share prices than changes in interest rates.

But if rates are being cut because inflation is considered under control and the economy is ticking along ok, then that could be good for share prices.

There could be a perception that over longer time periods, lower rates are positive for share prices. This is because it reduces the costs of borrowing for companies and encourages investment, which in turn could make companies more profitable.

However, over the long term there are so many factors that impact the stock market, it’s difficult to predict the specific impact of changes in interest rates.