Interest Rate Cuts & Their Impact on Stocks & Bonds

The US central bank (the Federal Reserve) announced a 0.25% reduction in interest rates on Wednesday. This was in-line with market expectations, following a series of weak job market data reports, suggesting the economy may be slowing.

Interest rate expectations are a key driver of stocks and bonds. In today's note, we highlight how interest rates impact each asset class and how this has impacted our Tactical Asset Allocation.

Stocks

Stocks generally benefit from a reduction in interest rates (should economic growth remain resilient), as borrowing costs become cheaper, enabling companies to borrow more in search of growth. In addition, interest rate cuts typically prompt a rotation of investor funds from cash to stocks (and bonds), as lower interest on cash savings makes the returns of stocks (and bonds) more attractive.

However, in an environment where the economy is struggling or in recession, stocks generally underperform, as corporate earnings growth is pressured and investor sentiment weakens.

Interest rate cuts also benefit company valuations. Here's why: analysts use something called the "risk-free rate" (i.e. current interest rates) to help figure out what a company’s future earnings are worth today. When interest rates drop, future earnings look more valuable now, which pushes up the company’s overall value.

Bonds

Bonds performed poorly through 2022/23, as investors grappled with rapidly rising interest rates across the globe. Bonds have remained out of favour as sticky inflation has seen interest rate expectations remain elevated and volatile (meaning bond yields have been elevated and volatile). However, we believe in the current environment that bonds are likely to play an important role in contributing to investor returns.

Government bonds generally appreciate in value following a reduction in interest rates, as their interest income becomes more attractive relative to the lower interest income on offer by newer bond issues. Corporate bonds on the other hand can vary due to their inherently higher level of credit risk (risk that the bond issuer cannot pay its interest payments), particularly when the economic environment may be weakening.

Omnis Chief Investment Strategist, Patrick O’Donnell, suggests interest rate expectations are arguably more important than the official action of cutting rates, as investors try to predict these moves before they happen. In the US, the market is currently pricing in a further 0.5% reduction of interest rates by the end of 2025 on top of yesterday’s 0.25% cut), while only forecasting a small chance of interest rate cuts in the UK and Europe.

T. Rowe Price – who have recently taken over management of the Omnis Strategic Bond Fund – conducted analysis of 12 US central bank rate cutting cycles spanning 70 years and found that bonds outperformed cash in all 12 cutting cycles, by an average of 8.1% annualised (highlighted in the table). While historical performance is not a reliable indicator of future performance, it does depict a supportive backdrop for bonds relative to cash.

Source: T. Rowe Price, who sourced this information from the Federal Reserve Board, July 2024. Bonds are represented by Bloomberg U.S. AggregateBond Index. Cash is represented by FTSE 3-month Treasury Bill; Ibbotson SBBI US(30-day); Treasury bills (cash). Figures have been converted into an annual rate in the table above.

Implications for your portfolios: Stocks

Stock markets provide exposure to a diverse range of companies and sectors, with some sectors and areas of the market deriving more benefit from interest rate cuts than others.

Omnis Chief Investment Strategist Patrick O’Donnell believes US Small Caps will benefit more from the reduction in interest rates than Large Caps, as they typically carry higher debt levels with shorter maturities, meaning they are more sensitive to movements in interest rates. Over the past month, the Russell 2000 Index (which encompasses 2,000 US small cap companies) has returned +5.5%, relative to the S&P 500’s return of +2.3%. This is supportive of Patrick’s view, with the market pricing in the interest rate cut ahead of time.

In our discretionary portfolios, we hold overweight exposure to US Smaller Companies in order to benefit from this changing macroeconomic environment.

Implications for your portfolios: Bonds

Following several weak labour market updates in the US, we remain cautious on the outlook for US economic growth. In combination with a backdrop of falling interest rates, we would expect appetite for US government bonds to increase. For these reasons, we hold a tactical overweight position in US Government Bonds.

With a myriad of inflationary forces facing the globe (increased government spending, higher tariffs and falling labour supply) against a backdrop of falling interest rates, we hold an overweight position to global inflation-linked bonds. Inflation-linked bonds work to offset the impact of inflation, which in an environment where inflation remains sticky, we would expect to see inflation-linked bonds outperform ordinary bonds.

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Issued by Omnis Investments Limited. This update reflects the views of Omnis, and its investment managers, at the time of writing and is subject to change. The document is for informational purposes only and is not investment advice. We recommend you discuss any investment decisions with your financial adviser. Omnis is unable to provide investment advice. Every effort is made to ensure the accuracy of the information but no assurance or warranties are given. Past performance should not be considered as a guide to future performance.