- Inflation falls below target for the first time in three years
- Markets are pricing in four interest rate cuts in the next nine months, with two cuts by Christmas
- Mortgage borrowers are stepping off expensive two-year deals brokered in the wake of the Truss/Kwarteng mini-Budget
- What lower inflation and falling interest rates mean for cash, bonds and equities
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“Inflation has fallen below target for the first time in three years, marking the final nail in the coffin of the inflationary burst which created so much financial pain and turmoil over the last few years. As ever the market pendulum now starts to swing in the opposite direction, as investors ponder whether the Bank of England has pushed rates too high, and if we might be in for a spell of below target inflation as a result.
“This latest inflation reading widens the pathway to lower interest rates, and markets are now expecting a flurry of interest rate cuts at the back end of this year and into next. Current pricing suggests interest rates will be around 4.5% by the end of this year and under 4% by the middle of 2025. Although inflation looks well under control, the rising energy price cap in October will exert upward pressure on the CPI number once again. On the other side of the ledger, sterling’s ascendancy on the currency markets will serve to reduce the price of imported goods such as commodities and textiles, though this effect can be expected to fade somewhat as we head towards the end of the year and start lapping a period of greater sterling strength. This latest inflation reading will also take its toll on the pound, as markets recalibrate their forecast for future interest rates in the UK.
“Lower inflation clearly exerts influence on asset returns too. Each percentage point of annual returns delivered by savings and investments now provides more bang for your buck when it comes to growing your spending power. Or, to look at it another way, falling inflation means savers and investors need a lower nominal return to achieve the same level of real return. While we shouldn’t read too much into one monthly reading of inflation, the central economic forecast looks to be one of falling interest rates over the next year. The change in monetary policy from here will not be as dramatic as the paradigm shift we witnessed as interest rates rose from historic lows through 2022, but it does present a new set of economic circumstances for investors to ponder.
Cash
“On the face of it lower inflation is good for cash savers, but expectations of interest rate cuts will feed their way into lower cash rates too. Nonetheless cash savers still have their head well above water when it comes to beating inflation, with the best rates still offering around 5%. With CPI coming in at 1.7%, it’s tempting to think this translates into a real return of 3.2%, but actually the latest inflation reading measures inflation over the last year, and it is future inflation which will impact on the real return enjoyed by savers.
“We’re due an updated forecast from the Bank of England, but their last monetary report suggested inflation would be around 2.5% over the next year or so. If interest rates fall in line with expectations, this will lead to a squeeze on the real returns enjoyed by savers in variable rate accounts. Getting any kind of real return will no doubt still be seen as manna from heaven for savers who saw their cash suffer death by a thousand cuts during the years of ultra-low interest rates. Given the outlook for rates to fall, the best deals for fixed term accounts still look pretty perky, and those who don’t need immediate access to their cash might consider if it’s a good time to lock in current rates.
Mortgage rates
“As interest rates fall we can also expect mortgage rates to dip, which is of course good news for anyone stepping onto the housing ladder for the first time. Lower rates are also good for those remortgaging, but how borrowers feel about coming off their old deal will very much depend on when it was brokered.
“Five year fixes coming up for renewal will have been taken out in the fourth quarter of 2019, when a typical rate for a 75% loan to value stood at around 1.7%, according to Bank of England data. These borrowers might be in for a nasty rate shock, though unless they’ve been living under a rock they probably know what’s in store. This serves to illustrate how some of the pain from higher interest rates is still in the post for the economy at large.
“By contrast anyone coming off a two year fix might well have brokered their deal in the fourth quarter of 2022, when the Trussonomics programme laid out in the mini-Budget wreaked havoc in the mortgage market. Average rates for a two year fix on a 75% loan to value hit 6% at that time, and some borrowers will have been stuck paying significantly more. Remortgaging in a market where the best two year fixes are coming in under 4% will seem like sweet relief to these borrowers, who felt the sharpest pain from the Trussonomics debacle.
Bonds
“Bond yields fell back as the latest inflation reading surfaced with the benchmark 10-year gilt yield falling from 4.2% to 4.1%. Lower inflation is good for conventional bonds, as it increases the value of their fixed income streams and serves to lower expectations for interest rates, pushing down yields and inflating prices. In theory gilt yields should reflect interest rate expectations over the term of the bond, and so it’s not the case that an interest rate cut will produce a commensurate fall in bond yields, or indeed have any effect whatsoever if it is fully priced in. However if inflation continues to come in below expectations, that would prompt markets to accelerate and deepen their forecasts for interest rate cuts, which would be positive for bond prices. Gilt yields have been rising in recent weeks, probably reflecting some jitteriness about the forthcoming Budget, which shows that government debt issuance and affordability also plays a part in government bond pricing, as do the Bank of England’s gilt sales as it seeks to unwind Quantitative Easing.
“Gilts are current yielding 4% at the two year maturity, which doesn’t look too sharp for savers when you consider the best two year fixed term accounts are yielding somewhere in the region of 4.5%, according to Moneyfacts. However the gilt yield starts to look more attractive for low coupon government bonds which offer a return which is almost tax-free, because gilts aren’t subject to capital gains tax. For instance a theoretical gilt yielding 4% delivered entirely through capital gains would be equivalent to an interest-bearing bond or savings account paying 6.6% in the hands of a higher rate taxpayer who had used their Personal Savings Allowance, or 7.3% in the hands of an additional rate taxpayer. Little wonder then low coupon gilts have been used as cash alternatives by wealthier individuals looking to manage their tax bill.
UK equities
“Lower inflation is also good for UK equities at it means dividends and capital growth look more attractive in real terms. A more buoyant consumer less constrained by inflation also spells good news for companies which sell discretionary items to UK households. Should they materialise, lower mortgage rates specifically would be good news for the housebuilding sector. On the other hand lower interest rates are a double-edged sword for banking stocks. Lower rates usually lead to a lower net interest margin for banks, but healthier consumer balance sheets also require banks to set less aside for bad loans.
“The prospect of lower rates also reduces discount rates on future profits, boosting their present values. Lower bond yields would also mean companies could take on debt at a lower cost, leaving more revenue to flow through to the bottom line. However, as mentioned above, falling interest rates don’t necessarily spell falling bond yields, which reflect movements in interest rate expectations. Clearly these expectations can be affected by interest rate movements, but it’s not a one for one relationship. Corporate debt also includes a premium for the risk of default, which will tick up if economic conditions look more troubled, or if the outlook for a particular company or sector deteriorates.
“Overall a period of falling interest rates and contained inflation provides some positive mood music for equities, though limp economic growth and a lack of investor confidence may continue to drag on performance of the UK stock market. More money in consumer pockets combined with lower variable cash rates might persuade more individuals to invest in the market, though when they do so it’s largely been via global funds rather than UK ones for some considerable time.”
