Have interest rates finally peaked?

The US Federal Reserve, Bank of England, and European Central Bank have in recent weeks confirmed that they will continue to hold interest rates at the same level that they've been at since July, August, and September 2023 respectively, and in each instance gave an indication that rates may now have peaked.

Since early 2022 the US, UK, Swiss, Australian and European Central Banks have increased rates incrementally from historic lows to check rising inflation - but as inflation has slowed, they are now expected to begin the process of loosening monetary policy by cutting interest rates in the months ahead.

European Central Bank

The European Central Bank [ECB] will have the opportunity to cut its (Refinancing [Refi]) interest rate at its next meeting [on June 6] if the Eurozone’s low underlying inflation trend is confirmed. The ECB held the rate unchanged for the eighth consecutive month at their meeting on April 11, but ECB President Christine Lagarde said that if a fresh assessment increased policymakers' confidence that inflation is heading back to target, then it "would be appropriate" to cut interest rates.

“If the Governing Council’s updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission were to further increase its confidence that inflation is converging to the target in a sustained manner, it would be appropriate to reduce the current level of monetary policy restriction,”
European Central Bank Statement – 11 April 2024

On the strength of this statement the markets subsequently priced in 1.00% worth of rate cuts for 2024 [versus 0.90% prior to the statement] having interpreted it as affirmation of a June 6 move.

US Federal Reserve

The US economy’s resilience and unexpectedly strong employment data in the first months of 2024 have created uncertainty in terms of the pace and trajectory of US inflation meaning that the US Fed is unlikely to cut interest rates until the Federal Open Market Committee [FOMC]’s meeting on June 12 at the earliest.

“If the economy evolves broadly as we expect, most Federal Open Market Committee participants see it as likely to be appropriate to begin lowering the policy rate at some point this year.”
Jerome Powell, Fed Chairman – 3 April 2024

The market anticipates however that US inflation will decline sufficiently to enable the Fed to make that initial rate cut in June, and that two further cuts will follow before the end of the year.

Bank of England

The Bank of England [BoE] is expected to ease rates later than the Fed and the ECB, but some economists are speculating that a weaker growth outlook for the UK economy could not only prompt an earlier move by the BoE, but also result in larger rate cuts overall.

The UK base rate has remained at [a 16-year high] of 5.25% since August 2023, but the BoE is softening its stance, with governor Andrew Bailey stating;

"We don't have to actually get inflation all the way back to target [of 2%] to cut rates for instance, what we have to do is be convinced that it is going there,"
"We should act ahead of time in that sense because we have to be forward looking."
Andrew Bailey, Governor of the Bank of England – 21 March 2024

At the BoE’s Monetary Policy Committee (MPC) meeting on March 21, eight of the MPC’s nine members voted to leave rates unchanged, with only one voting in favour of a cut. However, this marked the first time since September 2021 that no one on the committee voted for an increase.

65 of 68 economists polled by Reuters (between March 11 and March 14) forecast at least one cut to the BoE base rate by September.

After inflation data, published April 18, showed that UK inflation had only fallen from 3.4% to 3.2%, rather than the 3.1% that had been forecast, Andrew Bailey continued to strike an upbeat tone, insisting the latest data showed the UK was “pretty much on track” with the central bank’s forecasts, but the market reaction indicated an expectation that initial base rate cut would not now happen until November, or September at the earliest.

Australia

The Reserve Bank of Australia (RBA) on March 19 held its cash rate at 4.35% for a third straight meeting and in its statement removed specific reference to possible further increases, with RBA Governor Michele Bullock acknowledging that the board had changed its language around the need for more rate rises thanks to prevailing data showing the economy was broadly on track to getting inflation down to its target range of 2% to 3%.

Financial markets took the RBA’s change in language as confirmation that the next interest rate move would be downwards, pricing in a 0.25% rate cut for August.

Swiss National Bank

With inflation in Switzerland having fallen in February to 1.2%, Switzerland became the first of the major economies to cut interest rates.

"The easing of monetary policy has been made possible because the fight against inflation over the past two and a half years has been effective. For some months now, inflation has been back below 2% and thus in the range the SNB equates with price stability."
Swiss National Bank statement - 21 March 2024

The Swiss National Bank (SNB) cut its main policy rate (for the first time in nine years) from 1.75% to 1.50%, on March 21, and Swiss economists anticipate that it will make two further interest rate cuts, each of 0.25%, in June and September.

"We give no forward guidance regarding our future interest rate decisions, but it's clear we will look at the inflation forecast in three months. If necessary, we will adjust monetary policy at that time."
Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank - 21 March 2024

So, what does that mean for your investments and savings?

As detailed above, the consensus appears to be that rates have now plateaued, and although they may remain ‘higher for longer’ than some commentators and economists had anticipated in Q4 2023, or earlier this year, if data continues to assure the central banks that they are on target to meet their respective inflation targets then we can expect to see interest rates being cut in the coming months.

Equities and Bonds

After the Fed’s final interest rate hike in the last four cycles, both equity and fixed income returns were strong in the year that followed - and importantly for long-term investors the positive performance of these assets continued over a five-year period.

In the last four cycles, following the final Federal Reserve interest rate hike of each cycle (%) results have been front-loaded, with the first year delivering the greatest contribution and long-term investments significantly outperforming cash.

For equities, when central banks start to reduce policy rates, one key risk for the financial system dissipates, with companies’ and consumers’ borrowing costs reducing to provide a boost to the economy and for corporate profits. Historically, equity investors have ultimately seen the benefit.

And the same exposure to interest rates that hurt bonds in 2022 - when for the first time in 45 years both bonds and equities posted negative returns in the same calendar year- could now prove beneficial if rates begin to fall. To illustrate this, if we assume that the weighted average of the bonds’ duration (the measure of its interest rate sensitivity) is six years, then if yields decline by 1.0% in 2024 investors could see upside of 6% in positive price return, all else being equal. In combination, those income and price return components would equate to a hypothetical one-year return that could potentially venture into double digits, assuming credit doesn’t deteriorate meaningfully.

And a balanced strategy, comprising exposure to both equities and high-quality bonds, should also provide not only better than cash returns across the market cycle, but also resilience in the event that the economy slows or falls into recession.

Cash Deposits

As the central banks begin to reduce interest rates in the coming months, retail banks will quickly reflect these cuts in their deposit rates – so if you’re selling a property or a business, are about to benefit from a significant windfall, or have any other near term requirement to hold cash, then it will pay to research the market if you want to ensure that you maximise the interest income you generate on your deposit, as the spread could be significant and is likely to widen on a monthly basis going forward, with reductions already being priced in by some banks for longer terms.