Market Impact of Future Rate Cuts

By: Dave Rudd

Director of Sandbox Limited

Interest rates started going up in December 2015, when the U.S. Federal Reserve made its first rate increase in a decade under former Fed Chair Janet Yellen. That hike was from a range of 0% to 0.25% to a range of 0.25% to 0.5%. By July 2023, rates were at 5.25–5.50%. Since then, it has held rates at that level as it attempted to control inflation.

While the Fed has not signalled any coming decline in rates, a Morningstar ‘Economic Outlook’ suggests Fed officials will deliver hefty cuts over the next two to three years and bring the federal-funds rate to 1.75% to 2.00% by year-end 2026.

In terms of rate cuts, Canada has set it own agenda. Instead of following the U.S. lead, the Bank of Canada made its first-rate reduction in June of this year after holding rates at 5% for 11 months. A further reduction in July brought the rate down to 4.5% and this trend is expected to continue. TD Economics anticipates a lowering of the policy rate to 2.90% by year end 2024, with further reductions to 2.05% in 2025, before stabilizing at 2% for 2026 and 2027.

Central banks use interest rates to stabilize the home currency, add/reduce liquidity/credit availability in the system and ultimately, economic activity. By increasing interest rates, they make borrowing expensive, reducing liquidity and demand in the economy and ultimately calming down inflation.

For investors, it is critical to know how interest rate movement affects different asset classes.

One of the most significantly impacted asset classes is equities. Although interest rates do not directly affect stock prices, decisions made by central banks can lead to changes in investor sentiments. Higher interest rates make borrowing more costly. This can lead to a slowdown or higher expenditure. Additionally, reduced consumer spending can lead to lesser revenues for many companies.

Due to expectations of such declines and slowdowns, the stock market can see some negative sentiment. However, sectors like banking, insurance, and brokerage tend to perform well due to higher revenue expectations.

Rising interest rates can also lead many investors to move their funds from riskier assets like equities to safer instruments like bonds or debt securities.

The bond market reacts negatively to rising interest rates. When interest rates rise, existing bonds become less attractive to investors because as their value decreases, their yields rise. Iinvestors then tend to shift to new bond issues with higher interest rates.

However, issuers of new bonds must offer higher yields, which reduces the value of lower-yielding bonds already in the market.

There is also the impact on gold. Often called a safe-haven currency, it tends to lose its shine amid the rising interest rate scenario. In theory, with higher interest rates, fixed income securities become more attractive and investors opt to flee away from gold investments.

Additionally, gold is denominated in US dollars. Hence, when the demand for the US dollar rises due to an increase in interest rates, gold prices come under pressure.

Funds kept in fixed deposits or saving accounts may benefit from the higher interest rate.

Now, however, attention is shifting to the impact of declining interest rates on portfolios.

Eric Savoie, an Investment Strategist with RBC Global Asset Management, says the BoC is the first G7 central banks to lower interest rates, signalling that restrictive rates are no longer necessary because there’s been sufficient cooling in the economy to warrant a little bit of relief. When there’s a shift from tight monetary policy to one of loosening financial conditions, it’s either because the economy is genuinely weak and about to fall into recession or the economy is continuing to move in the right direction and stocks generally respond well in that environment.

While rate cuts can potentially be good for all asset classes as long as a recession is avoided, it can take a couple of quarters to figure out which way things are going to go. Longer duration, fixed-income assets tend to appreciate as rates fall when bond prices go up.

For stocks, it depends on what happens with the economy. If the economy does avoid a recession, then the lower rates will typically help boost stock market valuations and deliver positive returns to the investor in that environment.

However, it’s not necessarily a great environment for short-duration fixed-income assets like cash or GIC-like instruments. Many advisors are counselling on extending fixed income duration as inflation and the economy appear to be stabilizing in a lower inflation environment.

As investors, it is important to build robust and well-diversified portfolios and have the ability to easily examine alternatives. For advisors, it’s important to not follow hype, but to follow the facts. Sandbox provides the facts and looks to historical returns to source the DNA of an investment. We provide simple but unique DNA tools to identify investment lineage and patrimony. The Sandbox portfolio building application has extraordinary complementary data (ETFs, Global Alts from Nilsson Hedge, Mutual funds, Global Equities and more) that you need to examine and improve existing portfolios or to source complementary investments. This highly visual application has unique tools to identify unwanted beta at the portfolio, fund or security level. Sandbox also integrates equities and private funds in near instant visual displays. Test drives are available at www.sigmasandbox.com.

Investing in equities, debt and other asset classes can help in reducing the overall impact of interest rates. The question, then, is how long investors will wait to see if rates continue to drop as forecast before changing their portfolios.

Using a tool like Sandbox and comparing asset performance historically during times of rising or declining interest rates can help investors and their advisors make informed decisions.

Dave Rudd is director of Sandbox, a highly visual, interactive app for understanding and building investment portfolios.

daverudd@sigmasandbox.com

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