As the autumn nights close in and the leaves start to fall, so too are interest rates.
Futures markets are pricing that US interest rates will reach 3.4% by the end of 2025, while a cool inflation print of 1.7% in the UK last week was met with investors ramping up bets that the Bank of England will continue cutting at its next meeting in early November.
So, what do falling interest rates mean for investors? Let’s take a look.
When interest rates start to fall, stock investors could stand to benefit in general.
Looking at the US, the FED’s decision to cut interest rates by 0.5 percentage points to between 4.75% to 5% means that US businesses may pay less interest on debt and therefore may have higher potential earnings in the future.
Lower interest rates also provide a boost to the wider economy, enhancing consumer confidence, often with a knock-on impact on share prices.
There’s also a crucial technical reason why interest rates affect share prices: analysts use them to calculate stock valuations. Lower interest rates mean future earnings are worth more in today’s money leading investors and analysts to revise their valuations of stocks.
While this picture sounds rosy, reality is often a bit more complicated. Investors typically buy and sell assets based on their analysis of future earnings. As investors have become increasingly confident that the rate hiking cycle was about to reverse, prices have reacted accordingly.
The trick is to try to assess how far these changes have been priced in. If stocks are priced to perfection, any surprises in economic data could spell trouble.
While falling interest rates mean that financial conditions are gradually becoming less restrictive, there are also good reasons to be cautious.
Historically, central banks have cut interest rates in response to cooling economic data: falling inflation, rising unemployment, and fewer new job openings. This is exactly what central bankers in the US and UK set out to achieve when raising rates to stamp out inflation.
Now these same central bankers are trying to execute a challenging feat: stop cooling the economy quickly enough to avoid a recession, but not so quickly that inflation comes roaring back.
No biggie.
There’s still a very real risk that we may see economies like the US and UK enter into a recession. If that happens, stock investors looking to the future will become less optimistic. Companies will revise earnings projections down, and stock valuations could tumble.
Regardless of what happens next, some sectors will do better than others in a falling rate environment.
Falling rates are great for companies in rapidly growing sectors, such as information technology and communications, as their value relies heavily on expectations about future earnings. When rates drop, their valuations tend to get a boost.
Likewise, commercial property and infrastructure companies tend to benefit from falling interest rates. Falling rates could mean cheaper borrowing rates, which reduce these companies' costs. It could also make these assets more attractive to prospective buyers, encouraging an uplift in transactions that drives up asset valuations.
It’s not just stock prices that are impacted by falling interest rates.
Bond and gilt prices increase when interest rates fall as existing coupons become worth more compared to newer bonds and gilts. Prices on bonds and gilts often are less volatile than equities and can provide returns that are less correlated to stock market movements.
A simple way to get exposure to gilts or bonds is through an ETF that tracks a bond index. Those with exposure to longer duration bonds will be more sensitive to changes in rates.
In contrast, sectors like banking and energy tend to lose out.
Banks typically generate revenue from the difference between short-term borrowing rates and long-term lending rates. Lower rates will compress this spread and reduce revenue from banks’ net interest margin.
Additionally, with lower rates banks may earn more modest margins on loans.
The energy sector can be negatively affected as falling rates may indicate slowing economic growth and reduced demand for energy. This trend, however, may reduce if lower rates lead to an economic recovery and an increase in demand.
Although falling interest rates are great for many sectors, it’s important to remember that expectations will largely be priced into stocks. The recent bull run was partly fuelled by anticipation of these rate cuts.
We’ve also seen expectations about rate cuts reset numerous times since the end of 2023.
That’s an important cautionary tale that could spell significant stock market volatility ahead. Central bankers in the US and UK are closely monitoring key economic data, sounding like a broken record talking about their “data dependency”.
This means the path to lower rates may not be clear cut.
For investors, even small changes to expectations can have a big impact on the markets, so it pays to stay focused on a longer term horizon.
Rather than trying to time a soft or hard landing, one of the most effective strategies to smooth out stock market volatility is to set up a regular investing plan in your ISA or SIPP and keep at it consistently.
If nothing else, this type of investing strategy helps to smooth out the peaks and troughs through volatile and unpredictable markets.
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