Why lower interest rates rule

Markets suggest we are heading towards a 3% Fed Funds Rate and a 2% policy rate in Europe. That path is guided by softer economic data and the slow return of inflation towards central bank targets. It is good news for investors as fixed income and equity returns will be sustained by easier money, which also offers some assurance that slower economic softness does not turn into a recession. Risks to bonds come from expectations the US presidential election result will usher in an inflationary policy agenda. Risks to credit and equities are centred around growth data. For now, the middle path down the hill of the monetary Table Mountain looks the most reasonable.

Cheaper money

Households and companies are going to benefit from lower borrowing costs. Markets are unrelentingly pricing in large rate cuts over the next year. Last week I wrote how this bullish sentiment was reflected in bond markets’ recent strong performance and this should continue further. Lower borrowing costs will help corporate cashflow and come as a relief to households that need to refinance their mortgage or other debt. The narrative is that we are in a modest, late-cycle slowdown, which necessitates monetary easing globally. If a recession is avoided, it is good news for investors. Indeed, if central banks lower rates as expected, the chances of a recession will diminish. Returns remain on a solid path in both bond and equity markets.

Borrow now

Companies are taking advantage of much lower borrowing costs in advance of either the rates market backing up (because it might have gone too far, too soon), or credit spreads themselves widening if economic data continues to weaken. The (now) additional marginal cost of borrowing relative to the back book needs to be seen against an ongoing strong corporate earnings backdrop. There is no need for interest coverage to decline. This is positive for credit investors.

Searching for neutral

A higher neutral rate would mean that nominal policy rates could not be reduced as much as in previous cycles. At times there were those who argued rates would need to go even higher because a higher neutral rate (which cannot be observed) meant that policy was not as tight as central banks thought. Now, there is more sympathy with the view that the neutral rate might not have risen that much. As such, current pricing of terminal interest rates is reasonable. If the real neutral rate in the US is 1% and the inflation rate is 2%, then a 3% Fed Funds Rate represents a neutral nominal rate – not easy money. Two oft-cited estimates of the real neutral rate, published by the New York Federal Reserve, suggest it lies somewhere between 0.75% and 1.25%. Thus, a risk scenario in fixed income is the fear of recession grows and the expectation that rates below neutral will be needed and nominal policy rates might fall as low as 2% or below in the US.

Risks to rates

Key risks to the bullish pricing in bond markets could come from disappointment that inflation might not fall further, or the impact of a Donald Trump US election win, or a broadening of concerns about fiscal policy in developed economies. We will see with the inflation data but the numbers do seem to be coming down. On the election, Kamala Harris did well in the debate last week. Polls indicate a close outcome now but that could change in the weeks ahead. I will come back to the Trump policy agenda but the working assumption of bond investors is that Trump would mean higher inflation.

Of course, fixed income analysts and economists worry about budget deficits and increased government supply and the impact of excessive government spending on inflation. Some even suggest the cheapening of US Treasuries at the long end of the curve, relative to swaps (a measure that traders use to assess relative value for bonds), indicates some desire for more risk premium in long-term government bonds given the US fiscal outlook. At the same time, a 10-year Treasury bond auction this week went extremely well. Poor as the fiscal outlook is, it is too distant to worry the current bond bull market.

Bullish for now

For now, I remain positive on markets. Rates are coming down. That is reducing the attractiveness of government bonds but they remain more valuable than prior to the start of the tightening cycle. Credit markets looks stable, with strong issuance and demand. We are going to see cash deposit interest rates fall below yields on high-grade corporate bonds in the coming months - for the first time since late 2023. This should sustain flows into corporate bond funds. Today, the gap between the yield on US high yield bonds to the Fed Funds Rate is 175bp – that is going to widen and as it does it should attract money into an asset class that offers a better risk-reward than equities.

Drama faded

With all the focus on the rate moves, equities have taken a back seat recently. Yet it is hard to be overly bearish. Profits are healthy and earnings growth expectations have been rising. After recent wobbles, the S&P 500 is close to record highs again. Lower rates are good for stocks. I am confident that the 60:40 approach will continue to be rewarding into 2025.

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 12 September 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.