Interest rates peaking? What it means for your investments

INVESTORS on both sides of the Atlantic are wondering when we will see the end of interest rates rises. 

Monetary policy decisions this week in the UK and the US saw rates held, bringing relief to borrowers. And in both cases the question was the same - have we now seen a peak in rates? 

It may be too early to say that we have. The consensus expectation right now is that, despite holding rates in September, the US Federal Reserve will apply one further rise this year before gradually reducing in 2024. The Bank of England, meanwhile, warned that further rises may still come, although it seems happy to now wait to see the impact of rises it has already enacted. 

Most agree, however, that we are closer to the end of the cycle for rate rises than the beginning and that the path for rates is about to change. What will that mean for your investments? 

Relief for bond investors?

Interest rate rises have been bad for ‘fixed income’ investments, including all types of bonds. Bonds pay interest, and return a capital amount, which is fixed in cash terms.  

Both inflation and interest rate rises hurt bond prices because the returns they pay suddenly look less attractive - inflation will erode the value of the cash being paid out in the future, while higher rates for risk-free assets like cash mean the market will demand a higher return from bonds.   

To pay a higher yield, bonds need to fall in price and that is what has happened since central banks embarked on interest rate rises at the end of 2021. 

It’s been particularly painful because bonds are the traditional way to reduce risk in portfolios. The most cautious investors hold higher proportions in bonds and have suffered as a result. The average global government bond fund has lost around 10% in the since the start of 2022, according to Trustnet.¹ 

Some of those losses will be recovered if interest rates unwind. That’ll be a relief to bond investors but they should also manage their expectations somewhat. It could be a long wait as central banks have signalled they will wait to see if the rate rises they’ve already made will be effective in bringing inflation down. The Bank of England has said that, according to the path implied by the market, UK rates will average 5.5% over the next three years - that’s higher than the current rate of 5.25%.  

Those assumptions may fall - particularly after the Bank held this week - but it’s clear rates will stay near their peak for a while. And once they do fall it is unlikely that they will cut to levels seen prior to 2022. 

Different types of bonds will feel the effect of rate falls differently. High-quality bonds, including government bonds, with relatively long ‘durations’ will be most impacted. This means bonds which have longer left before they mature and return capital to bondholders. Shorter duration bonds are less exposed to inflation and interest rate changes. 

High-yield corporate bonds could benefit from rates unwinding but are also likely to be adversely affected by a worsening of the economic outlook implied by that, which increases the chances that issuing companies default.    

Growth vs value

Rate falls will also be felt in the stock market. Overall, lower rates should be positive for shares as it means fewer restrictions on the economy, but different parts of the stock market will feel the effects differently. 

When rates began to rise in 2022 it was ‘growth’ companies that were worst hit. Growth companies are those which the market views as being able to grow their earnings steadily into the future, perhaps because they are in expanding markets or utilising new technologies that will grow in significance. Investors are prepared to buy these companies on higher valuations. 

When inflation and rates rose, the earnings that the market assumed these companies would make became worth less, and share prices fell as a result. 

‘Value’ companies fared better. These are companies that may be producing strong earnings in the here and now but which look less likely to grow their earnings in the future, perhaps because they are operating in mature markets where the scope for big improvements is lower. These often trade on lower valuations, but they are less exposed to the inflation and interest rate risk. 

Up until 2022, value had been trailing growth for many years, ever since the financial crisis brought about very low interest rates to stimulate growth. This chart shows the performance of two indices covering the US stock market - one for growth companies and one for value. 

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.