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The monthly review: September's close look

4 months ago

CLOSE LOOK
RATE CUTS - WHAT’S THE BIG STORY?

The US Federal Reserve (Fed) has cut interest rates for the second time in a decade. The European Central Bank (ECB) has followed suit, while the Bank of Japan is planning to cut soon. Why the headlines? It’s about more than simply the money you can earn at the bank. We cast an eye over interest rates and why they matter to investors.

Why cut rates at all? It’s a response to forecasts of slower economic growth. Lower rates mean borrowing becomes cheaper. They encourage companies to raise money for investment projects. And consumers to borrow for their homes, or perhaps a dream holiday. That boosts economic confidence, potentially setting growth back on an upward trend.

Equity markets get a kick from lower rates. A sound economy should allow company profits to grow and investors to feel optimistic about future dividends. But this is not true for every sector. Banks, for example, can take a hit when rates are cut. Profits shrink if the gap between the interest rate on their borrowing and that on their lending is squeezed.

So what about the bond markets? If a bond price goes up, its yield (or the income from the bond) goes down. They always move in opposite directions. If interest rates fall, bond yields tend to fall with them. Which mean the price of the bond rises. One wrinkle on valuations - rock bottom bond yields make sky high equity prices look justifiable. Potentially adding fuel to a bull market.

Just how low can rates go? Tricky to say for the ECB and the Bank of Japan. They are already in negative territory. The US Fed has more scope to cut rates. But markets are already hoping for a whole sequence of Fed cuts, which could bring disappointment. And as rates sink the benefit of each cut diminishes. As the economist JM Keynes wrote, it’s like ‘pushing on a piece of string’.

 

 

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