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Written by: Hal Cook | Hargreaves Lansdown
- The European Central Bank (ECB) cut rates again on 12 September, the Bank of England (BoE) has cut once but held today.
- The Federal Reserve (Fed) cut for the first time by 0.5% yesterday (18 September).
- With inflation broadly under control, what’s next for rates?
- Fund picks for a rate cutting cycle.
Rates are falling. The European Central Bank (ECB), the Bank of England (BoE) and the US Federal Reserve (Fed) have all cut interest rates. The Fed’s first cut of 0.5% was bigger than the equivalent cuts by the ECB and the BoE, although as the ECB has cut twice the total amount of cuts is also 0.5%. With the BoE holding rates today, they’ve only cut by 0.25% so far.
After a period of rising rates and then stable, relatively high rates, this is the natural next step.
What the Fed says about the future of US rates
They expect US rates to come down further in 2024, probably by a further 0.5%. Looking further out to the end of 2025, they are expecting a further 1% of cuts, taking the base rate to somewhere in the region of 3-3.5%.
There is 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. And it’s worth noting that one member of the committee only wanted to cut by 0.25% this time around – the first time the decision hasn’t been unanimous since 2005. This highlights that predicting where rates will go over longer time frames is difficult as there are lots of things that can impact potential future changes.
Expectations in the UK
As the BoE held rates today, there remains an expectation that there will be at least one further cut in the UK before the end of 2024. In terms of size of further cuts this year, they’re likely to be either 0.25 or 0.5%. All eyes are on the next meeting in November. Looking further out, it’s less clear what might happen to UK rates. But it seems more likely that we’ll see further cuts as opposed to rate rises given the general economic picture of lower inflation and limited growth.
Themes to impact the journey for rates
The key factors that could slow the pace of rate cuts or even stop them are inflation and economic strength. If inflation moves higher again meaningfully, central banks will need to act to try and stop a repeat of high levels of inflation again. They would do this by either not cutting rates any further, or possibly by increasing them a little.
Economic strength feeds into this a lot. If the economy is growing strongly, that can trigger inflation. Partly because it can cause higher levels of wage increases and partly because it typically increases demand. Both of these things can result in inflation and hence central banks will change their stance on the direction of rates.
Another factor to consider here is the potential for increases in government spending (also called fiscal policy). With the new government’s first budget in October here in the UK, and the US going to the polls in November, it’s quite possible that there will be big changes to fiscal policy. This could filter into economic strength or inflation or both.
However, there are also things that could cause rates to fall further than expected, or more quickly. A recession is most likely the biggest risk here. 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.
And there is always the potential for an unknown market shock that could cause rates to rise or fall significantly. Covid is a recent example that caused a big and quick drop in rates.
For now though, the base case is that rates continue to come down, in a measured way, both here and across the pond.
Funds for a rate cutting cycle
Invesco Tactical Bond is very well placed to take advantage of a rate cutting cycle. They’ve been altering their investments to benefit from rate cuts more recently. This is best illustrated by their duration position which, at around 7 years, is close to the highest it has been over the last ten years in the fund. Duration is a measure of how sensitive an investment is to interest rate changes and is measured in years. The higher the duration value, the more sensitive the investment is to interest rate changes.
If it’s shares you’re looking at, then smaller companies present an interesting opportunity in a rate cutting environment. Smaller companies have generally struggled during the period of rising rates. This is partly because their revenues can be more linked to the health of the economy and partly because their cost of borrowing is often not fixed. The opposite is true as rates come back down, making them an interesting investment.
Smaller companies in the UK could be a good place to invest, especially with this part of the UK market trading on a significant discount to their larger counterparts. The FTF Martin Currie UK Mid Cap fund is a good option in this space. Richard Bullas has managed the fund since 2013 and is a UK smaller companies’ expert that we hold in high regard.
Finally, for more cautious investors, multi-asset funds might be appealing - particularly those with investments in bonds and investment trusts. Investment trusts have struggled during the rate rising cycle, especially those that invest in property and infrastructure. This is largely because one of the key attractions of these trusts is the income that they pay. As interest rates and bond yields have increased, the demand for these types of trusts has fallen because the level of income they pay is not much more than cash or bonds now. This has resulted in a number of them trading at a discount to their net asset value. On a forward-looking basis, this has the potential to reverse and add to the returns of these trusts, however, there are no guarantees.
The Baillie Gifford Sustainable Income fund is a good option in this environment. It’s neutral asset allocation includes around a third invested in infrastructure and property and a further a third invested in bonds. The remainder is usually invested in shares and cash. It’s managed by a number of experienced individuals at Baillie Gifford and the diversified nature of the fund means that even if rate cuts have differing impacts on different regions and asset classes, the fund has potential to benefit from them.
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