IN FOCUS6-8 min read

Peak rates? Options for investors

With inflation declining in many parts of the world and the US Federal Reserve signalling it may cut rates next year, there is rising hope that interest rates may have peaked. Schroders’ specialists discuss investors’ opportunities across assets.

18/01/2024
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Authors

Schroders Economics Team
Remi Olu-Pitan, CFA
Head of Multi-Asset Growth and Income

The recent decisions by the US Federal Reserve (Fed) and Bank of England (BoE) to hold rates at the 5.25% range suggest that we might have seen the peaks. Now is the time to consider what to do when rates peak, given that some believe they will remain elevated for longer.

Have interest rates peaked?

It looks very much that they have and the principal reason behind that is the improvement in inflation. It has come down, and down quite dramatically across the world. In the US, inflation was about 9% a year ago; it is now around 3%. In Europe, the improvement has been even more dramatic, down from about 10% to less than 3%. In the UK, it is also come down quite a bit but it is still around 4.5%, but that is down from more than 10%, so it is a big improvement. This has led people to think that the central banks have done their job and markets are now looking for rate cuts in 2024.

For the US, we think the first rate cut will be in September 2024. The ECB and the BoE are not just looking at lower inflation, but also quite weak economic activity with a higher risk of recession. So, we think the ECB could cut as early as March and the BoE probably in May 2024. We do think that rates have peaked but there is going to be a difference in the speed at which they come down.

Is a peak in rates good news for investors?

The fact that inflation has peaked – and for the right reason because inflation is coming down – is a good reason to celebrate. That is certainly what financial markets – both equities and bonds - are doing. So, we are seeing a positive correlation because rates have peaked. However, we won’t be here forever and in 2024 we expect rate cuts, so what will lead to those cuts will need to be priced into the markets.

If the rate cuts come about because growth is falling faster than inflation, then that is problematic. That will be an environment when equities will struggle, and bonds will do well. We don’t think we have enough evidence of that just yet and that is one of the reasons why rate cuts are not expected until the later part of 2024.

As we go into the new year, and certainly from the second quarter, we will have to think about if the Fed needs to cut rates, why is that happening? Is it because unemployment rates are rising, is it because there are cracks in the economy? That is not a great environment for risk assets.

What is the impact of the divergence in fiscal policy around the world?

Japan is going in very much the opposite direction, because rather than rates having peaked, they will be going upthere. There has been talk recently from the Bank of Japan, preparing the ground to make a move. We think this won’t be until spring 2024, but they want inflation to be sustained in an upward direction.

What we have been highlighting as more of a global concern is the fiscal position of global governments. The level of debt in the OECD has moved up significantly. It moved up quite considerably after the global financial crisis (and it never came back down) and it moved up again after Covid. It has come down a bit, but it has not got back to where it was before.

If we are talking about unemployment having to go up to ensure inflation comes down, then that will mean more benefit costs and less taxation being raised. Budget deficits tend to get worse, and the concern is that we are not starting from a very good place. The budget deficit in the UK is just under 5% of GDP; in the US it is 6%. At this stage in the cycle these numbers should be 1% or 2%.

The divergence of monetary policy provides opportunities, so from a multi-asset perspective that we embrace this because it helps from an asset allocation point of view. Divergence also means that the correlation across fixed income markets should subside.

In summary:

The rise in rates and yields has clearly weighed on risk assets, but as rates come down investors can start to see liquidity coming back and start to go back to risk assets. However, a lot of the debate will be about how quickly rates come down and where will they level out. Don’t look at the past decade, which was an aberration. What we are looking at is interest rates maybe levelling out at about 3.5%. That is the number people need to have in mind when they are thinking about the long term.

It is good to stay in risk assets for now. If central banks achieve their target of a soft landing with growth stabilising, that will continue to support risk assets. However, maybe it is time to fish in areas that have not done well in 2023. Therefore, if rates have peaked and growth stabilises, it is a good opportunity to think outside of the US, to look at value and small caps; the unloved areas that should do well in this environment.

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Authors

Schroders Economics Team
Remi Olu-Pitan, CFA
Head of Multi-Asset Growth and Income

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