Interest Rates and Their Impact on the Economy

Central banks are responsible for setting interest rates in their respective economies in order to manage the money supply and financial system (amongst other responsibilities). These central banks from the major economies are diverging in the speed of their likely interest rate cut strategies over the coming months after following a broadly consistent path up till now (see chart below):

In the US - The Federal Reserve (Fed) is most likely to cut interest rates by 0.25% in November (following a 0.5% cut in September) and a slow pace of cuts thereafter given US economic strength
 In the Eurozone - The European Central Bank (ECB) cut interest rates last Thursday for the third time this year (by 0.25%) and is likely to maintain sequential interest rate cuts at its future meetings, given “the disinflationary process is well on track” but growth is at risk of slowing
 In the UK - The Bank of England (BoE) may accelerate its interest rate cuts, with the most recent inflation figure lower than expected. 

So what is the impact on the economy of falling interest rates? Falling interest rates generally have a stimulative effect on the economy. Here's how:

•    Cheaper Loans: Lower interest rates make borrowing money cheaper for people and businesses. This encourages them to spend more on things like houses and cars, and businesses to invest more, which helps the economy grow. But if rates stay too low for too long, it can lead to too much borrowing and cause inflation.
•    More Spending: With lower interest rates, people have more money to spend on other goods and services because they pay less on their loans and mortgages. This extra spending boosts the economy.
•    More Investment: Businesses are more likely to take loans to expand, start new projects, or hire more staff when borrowing is cheaper. This also helps the economy grow.
•    Higher Asset Prices: Lower rates make bonds and savings less attractive, so people invest more in stocks, real estate, and other assets, which increases their prices. When the central bank cuts rates during good economic times, it can boost the stock market. When rates go up, it can slow down the stock market, but this effect can be hard to see if the economy is strong.
•    Weaker Currency: Lower interest rates can make a country’s currency weaker because foreign investors find it less attractive. A weaker currency can help a country export more by making its goods cheaper abroad and reduce imports, providing a boost to domestic growth.

The link between interest rates and bond yields is complicated and often debated. Central banks set short-term interest rates and sometimes, they also influence longer-term rates by giving guidance or buying/selling bonds, known as “quantitative easing” when buying bonds, or “quantitative tightening” when selling bonds. There are two main factors that affect bond yields: 

•    Expected Short-Term Rate: If inflation is high or the economy is growing strongly, markets expect interest rates to rise (in order to curb inflation), which increases bond yields. If central banks are expected to cut rates, bond yields might fall.
•    Bond Risk Premium: This is the extra return investors need for taking on uncertainties like interest rates, inflation, and credit quality. If there’s uncertainty about future rates or inflation, the risk premium goes up, which can increase bond yields even if short-term rates are falling.

How do bond yields feed through into mortgage rates?
Given this risk premium or expectations, some investors think bond yields should rise even if short-term interest rates fall because they may expect inflation to stay high, the final interest rate to be higher than expected, or more uncertainty about rates and inflation. This explains why mortgage rates don’t always follow short-term rates closely. In the UK, mortgages are linked to shorter-term bond yields, while in the US, they are linked to much longer term bonds. This means US mortgage rates respond less directly to short-term interest rates and therefore these arguments seem stronger for the US than the UK, so US bond yields might rise more compared to UK bond yields.

Building a diversified investment strategy helps protect portfolios from changes in interest rates, bond yields, or mortgage rates in a specific market. However, it is true that short to medium term experience is influenced by the economic cycle and overall market conditions. Diversity can only go so far in protecting investment portfolios against such factors. Whilst investment managers anticipate and adjust exposures in advance of these swings (e.g. via asset allocation shifts or use of downside risk protection), they are one of the main drivers of investment risk, which can’t be completely avoided.

The Noise

• The dollar has continued to strengthen this week, building on its steady climb since August. The dollar index, which tracks how the U.S. currency performs against other major currencies like the euro and yen, currently stands at 104.30, indicating that the dollar is relatively strong compared to global currencies. This ongoing success of the dollar can be attributed to an expected slowdown in rate cuts by the Federal Reserve, as economic conditions are better than anticipated. Signs of a stronger job market and a slightly more stable economy are reflected in the falling U.S. jobless claims, which came in below expectations. In response to this positive economic outlook, U.S. Treasury yields have risen to 4.26%, marking a three-month high. As of Friday morning, the dollar sits at 0.77 and 0.92 to the pound and euro respectively.

• Consumer spending is increasingly shifting from established Western brands to more affordable Chinese alternatives. This trend is reflected in the difficulties experienced by companies like Starbucks and L’Oréal, while their Chinese counterparts, such as Proya Cosmetics and Luckin Coffee, continue to thrive. Note that there are concerns about the climate impact and labour conditions for some of these companies. This change in consumer behaviour is not surprising, given the rise of online shopping and the growing cost of living, prompting many to seek out cheaper and more convenient options. The decline of the UK high street over recent years highlights this shift. However, the growth of emerging markets like China can be viewed positively. The MSCI China index saw a rise last month, driven in part by the momentum of these growing Chinese companies, with consumer discretionary spending comprising one-third of the index's weight.

• The EU allocated €4.8 billion from emissions trading revenues to fund an array of net-zero initiatives in 18 different countries. This tangibly translates to a reduction of emissions by approximately 476 million tonnes of CO₂ over ten years, across 85 individual projects. This initiative focuses on clean technologies, specifically in the maritime, aviation, and road transport sectors. Specifically, some projects include reducing emissions in the maritime sector by building and retrofitting vessels for renewable fuels and electricity use. Also, they are aiming to support the production of 525 kilotons of sustainable transport fuels per year. This is not a one-off investment; looking ahead, they are launching a new call for proposals for this fund before the new year, looking for more innovative projects across the eurozone that deploy net zero and clean tech solutions.

The Numbers

The Nuance

The UK’s budget next week might be the most talked about budget in a while. Though we don’t have a crystal ball to predict Rachel Reeves’s potential tax cuts, we can examine how the economy has performed in anticipation of her announcement. The government have suggested that this budget will be tough but is intended to foster growth and investment in the UK. Ahead of this, the UK’s economy has seen a mix of challenges and cautious optimism.

Public sector net borrowing rose to £16.6 billion in September, exceeding official forecasts. This figure underscores the fiscal challenges facing Chancellor Reeves. While tax revenue has increased, it hasn’t kept pace with rising expenses, particularly due the higher debt interest and public sector pay increases. Despite this, it’s important to note that Reeves has promised not to increase income tax, VAT, or national insurance for employees.

It shouldn’t be a surprise that consumer and business confidence is lower this month, with the GfK consumer confidence index falling to its lowest level this year - in line with the anticipated figures. All these statistics reflect a climate of uncertainty as households brace for potential tax increases. Despite falling inflation and a rebound in wage growth, many consumers are prioritising saving over spending, indicating a cautious outlook on personal finances. Hospitality businesses are also feeling cautious, this comes as their margins remain minimal, so they have less room to play with; The British Beer and Pub Association recently revealed that landlords make 12p profit per pint. 

However, there are reasons for tempered optimism. Reeves has indicated a shift in fiscal policy, aiming to support investment while grappling with the constraints of current spending. By adjusting fiscal rules to include a broader measure of public debt, she aims to free up additional borrowing capacity to fund vital public sector investments—an approach that could provide a much-needed boost to the economy.

Moreover, Reeves's commitment to investing in infrastructure and public services signals a long-term strategy for sustainable growth. By focusing on public investment, the government hopes to lay the groundwork for economic stability, contrasting sharply with previous policies that prioritised short-term gains at the cost of long-term viability. In summary, while the upcoming budget brings with it a host of uncertainties and potential tax rises, it also presents an opportunity for the UK to re-evaluate its fiscal strategy and concentrate on investments and fostering growth.