What Does The Market Do When Rates Get Cut?

For the past 18 months while interest rates have been ticking up, I’ve been on a variable rate mortgage¹ which has proven to be relatively painful.

Still, it’s all relative.

And so imagine the scenes in the Henry household this week as the Bank of England decided to cut interest rates for the first time since 2020. I’ve had a pay rise and I’ve had to do absolutely nothing to get it - wahey.

Inflation has been coming down and has now hit the Bank of England’s official 2% target - so it isn’t a massive surprise that they have cut. But it did come a little earlier than most expected.

Rate cuts obviously help borrowers, and anything that can help make it slightly more affordable to get folks onto the housing ladder is to be welcomed frankly.

Saying that, if rates come down materially it’ll probably just juice the housing market even more unless our new government can sort out the absolute state of the planning laws in this nation of ours, and we might finally get around to building some homes.

Cuts are less good news for savers. I have a sneaking suspicion that the period that we have just been through will be as good as it gets for cash returns for a while. In a few years, getting over 5% on cash might seem like a distant memory - it depends on what happens with the economy really, but it does feel likely that we will see some economic pain at some stage and that is not the kind of environment where you’d expect to see rates going up materially.

There is also the fairly large issue of the country’s post COVID debt load - which becomes less expensive to service as borrowing costs fall. So there’s a fairly large incentive to get rates down from where they are even today.

As you know, we aren’t in the business of making predictions round here and what I thought that I would do this week is look at what equity market returns have been in the past when interest rates have started to come down.

Below I have shown the returns for the FTSE All Share (the broad UK equity market) in the 12 months following the Bank of England’s first interest rate cut of a new cycle.

Source: FE Analytics. Returns are quoted without any costs and charges being deducted. Data available for FTSE All Share from January 1985.

So, largely positive actually. But that doesn’t tell us much because market index returns over 12 month periods tend to be positive. The average calendar year return for the FTSE All Share since 1985 is 9.95%, so we can see that returns in the twelve months following a rate cut tend to be a little worse than the calendar year average, but not by much.

Maybe not so much this time around yet, but it is important to remember that rates are usually being cut because the economic environment is getting worse. December 2007, great example, we were just on the cusp of the Great Financial Crisis.

All of the big negative numbers above were during periods of significant economic turmoil - the really big stock market drawdowns all tend to be accompanied by a recession, and during recessions central banks use interest rate cuts as a way to try to stimulate growth.

But there are some periods of positive return in the above table too - and there is certainly enough of a dispersion of outcomes to render making any predictions based on the above numbers fairly foolish.

If you are selling out now based on some fear of coming economic turmoil, the odds are not on your side because markets tend to go up. That’s just what they do.

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I do think that we were due a bit of a pullback in the market. Everything has gone up in a straight line since the beginning of the year.

The below chart is the classic one that we put in front of clients to remind them that a) during most years the market falls by more than 10% in value; b) in most cases it will recover to pop green by the end of the year; and c) sometimes it doesn’t and that’s just the risk we all take.

Source: Dimensional. I have used the numbers for the US market this time, because most investors will be globally diversified (as is sensible) and the US is the largest and most important market in the world.

It is important to be reminded of such facts when the sun is shining and things are going well because difficult periods for investors are a common and regular occurrence. Not something out of the ordinary, or to be frightened of.

I’m in a WhatsApp group with a few fellow investment pros, and we’ve been saying for a few weeks now that we are probably due a pull back. A bit of froth needs to be blown off the top - things were a bit too good.

These might be our views, but what are any of us actually doing with this information? Absolutely nothing, no changes. Continue to buy, continue to hold and certainly not selling. For folks like myself, who are in the saving phase of life - lower prices are a God send and should be welcomed with open arms.

For the prepared investor, who knows how the world works and has her plan in place - a temporary fall in the value of her portfolio is at worst an inconvenience and at best, an opportunity.

Have a great weekend.

1. My choice, trying to be clever. WRONG.