It is fair to say that monetary policy decisions taken by central banks have been a leading driver of market sentiment since the start of the Covid-19 pandemic. Investors have been keenly watching for signs that UK interest rates would begin to fall, after the rapid series of hikes during 2022 and 2023 pushed base rates from 0.15% to 5.25%.
The first sign that a rate cut may be on the cards followed the Bank of England’s Monetary Policy Committee (MPC) meeting in February, which saw the vote split three ways, with six members voting to keep rates on hold at 5.25% and two members voting to hike rates further, to 5.5%. One Committee member voted to cut rates to 5%, the first such decision since the MPC started to raise rates in December 2021.
Both the MPC and the US Federal Reserve changed their language in the final quarter of 2023, which suggested the battle with inflation was nearing an end. This led to a sharp rally in both equities and bond markets, as investors welcomed the prospect of easier monetary policy. US bond markets began to price in multiple rate cuts, with the first coming as early as March, and UK Gilt yields also fell on the prospect of imminent central bank action.
Since the start of the year, however, investors have had to temper the expectations of rate cuts. US economic data continues to prove highly resilient, with GDP growth remaining strong. As a result, bond markets have reacted to the stronger-than-expected data by paring expectations of multiple rate cuts, and pushing back the start of the rate cutting cycle to June.
It is a similar story in the UK, where Gilt yields have risen back towards level seen in November 2023. This is despite the news that the UK economy fell into recession at the end of last year, and it is clear that the higher borrowing costs are affecting consumer confidence.
Inflation – one of the primary reasons for the rate hikes seen over the last two years – has fallen back from a peak of over 10% in October 2022 to stand at 4% in January, and economists expect inflation to fall further towards the target of 2% over coming months. Recent comments from Bank of England Governor Andrew Bailey have indicated that the Bank do not need to see inflation reach their 2% target before action is taken to cut rates.
Over the medium term, the MPC’s projections show lower base rates are likely. Forward market interest rates imply a rate of 3.9% in 12 months’ time, and 3.3% by the start of 2026. These projections are, of course, subject to revision, although it is interesting to note that the rates projected for early 2025 and 2026 have been lowered somewhat from the Bank’s own projections just three months earlier.
The MPC are, however, making no comment on the pace of rate cuts, or indeed when the first cut will arrive. One reason behind this may be the potential for global events to cause inflation to spike again. In the wake of the Red Sea attacks on global freight, the cost of shipping has increased significantly since the start of the year, although costs have moderated a little over the last couple of weeks. The increased cost of shipping, and delay caused by ships using sub-optimal routes, could be inflationary. The wider conflict in the Middle East could also cause oil prices to jump, which would feed into higher prices generally.
Prevailing and expected interest rates and inflation data have an important role in determining the performance of corporate and government bonds. Higher inflation, and interest rate increases, make bonds look less attractive, as higher rates on cash deposit mean investors will demand a higher return from bonds to compensate for the additional risk over cash.
In order for bonds to remain attractive, they need to pay a higher yield to compete with cash interest rates, and as bonds pay a fixed rate of interest, prices fall as yields rise. Both UK and Global bond prices fell sharply during 2022, as markets expected higher interest rates. Conversely, as markets now expect interest rates to fall, this may well prove to be positive for bonds, where yields become increasingly attractive compared to falling cash interest rates.
We feel that bond investors do, however, need to take a sensible approach to how their portfolios are allocated. A weakening global economic outlook could increase the rate of default on lower quality bonds, where the most attractive yields can be found. Whilst longer duration bonds may be the most sensitive to changes in interest rates, they are likely to be more volatile and susceptible to any disappointment in the pace or timing of rate cuts.
Lower interest rates also impact equities markets, but to a lesser extent. A drop in the cost of borrowing may well be welcome news for heavily indebted companies, and equities generally feed off the boost in sentiment that less restrictive monetary policy could bring. Expectations of lower rates have been the main catalyst in the sharp rally in equities this year, particularly in the US.
Markets are at an interesting point in the investment cycle, where the prospects for improved performance from bond markets are competing with positive momentum in global equities. We feel these are conditions where a well diversified portfolio could perform well. Cash will always remain an important element of any sensible investment plan; however, this brief period of strong returns from cash deposit may be close to ending. Whilst we do not expect interest rates to fall back to pre-pandemic levels in the medium term, cash is likely to be less attractive when compared to the opportunities for superior returns from asset markets.
We believe this would be a sensible time for those holding significant allocations on cash deposit to consider alternative options. Our experienced financial planners are on hand to provide tailored and independent advice on how to best construct an investment portfolio to meet your needs and objectives.
