Central Banks Lowering Interest Rates: What It Means for the economy and your portfolio

Elevated inflation has driven up consumer prices in recent years, starting in 2022 when the U.S. experienced one of the highest inflation rates in four decades. This spike was largely triggered by the COVID-19 pandemic and global events, such as the war in Ukraine, which severely disrupted supply chains and pushed prices higher.

In response, central banks began raising interest rates in 2022 and continued into 2023 to combat higher inflation. The aggressive tightening of monetary policy gradually brought inflation down toward the central banks’ target of 2%.

By 2024, inflation has moved closer to the 2% mark, prompting central banks around the world to start lowering interest rates in recent months. This shift in global monetary policy may seem distant from daily life, but interest rate changes significantly influence both the broader economy and personal finances.

Why Do Central Banks Lower Interest Rates?

Central banks use interest rate adjustments as a key tool to manage economic activity. When a central bank lowers interest rates, the objective is to stimulate economic growth. Here is how it works:

1. Cheaper Borrowing Costs: Lower interest rates make it more affordable for individuals and businesses to borrow money. Companies are more likely to take out loans for expansion or investment, and consumers are more inclined to finance major purchases like homes or cars. As a result, the increase in spending can drive economic activity.
2. Encouraging Investment: When interest rates go down, investors tend to rethink where they put their money. Since savings accounts offer lower returns, people are often motivated to explore higher-risk options like stocks, real estate, or other investments that might provide better returns.
3. Weakening Currency: Interest rate cuts can cause a country’s currency to lose its value. In a lower rate environment, investments denominated in that currency may see smaller returns, leading to a decrease in demand. However, a weaker currency can benefit a country by making its exports cheaper and more attractive on the global market.

The Potential Downsides of Interest Rate Cuts

While there are many benefits to central banks lowering interest rates, there are also potential drawbacks as well.

1. Debt Accumulation: Cheaper borrowing costs can lead to excessive leverage, where businesses and consumers take on more debt than they can handle. If interest rates were to rise in the future, the increased debt load could result in financial strain or instability.
2. Asset Bubbles: When investors move to higher-risk assets like stocks or real estate for potential higher returns, there is a risk that prices could get pushed too high. If these inflated prices were to suddenly drop, it could lead to serious economic consequences.
3. Diminished Savings Growth: For individuals who prefer a conservative approach or need access to their funds soon, low interest rates can be discouraging. With savings accounts offering very little return, it becomes more difficult to grow savings, especially for those who depend on interest income, such as retirees.

How to position Investments for lower interest rates?

In a low-interest rate environment, it can be challenging to feel content with minimal returns, which often requires investors to adjust their strategies. Here are some considerations:

• Owning bonds: If you own bonds issued when rates were higher, those bonds may now offer more attractive returns compared to newly issued bonds at lower rates. While new bonds reflect the current low-rate environment, older bonds will continue paying the higher rates they were issued with.
• Diversify Fixed Income: To enhance income, you could consider diversifying your fixed income investments with high-yield or emerging market bonds. Though they carry higher risk, they also offer higher potential returns.
• Increase Equity Allocation: Allocating more to stocks can be a smart move in a low-rate environment, as equities often perform well when rates are cut. Small-cap companies tend to benefit more from rate reductions, as they typically carry more debt. However, any increase in stock exposure should match your risk tolerance and investment timeline.
• Real Estate and Housing: Lower interest rates usually lead to reduced mortgage rates, which is positive for real estate investment trusts (REITs), homebuilders, and related industries. As real estate becomes more affordable, both residential and commercial real estate markets tend to grow, creating new investment opportunities.
• Exchange traded funds (ETFs): ETFs offer a simple, cost-effective way to invest in specific sectors, industries, or commodities. They provide access to a diversified portfolio, typically with lower risk compared to buying individual stocks. However, investors should keep in mind that potential returns from ETFs may not be as high as from individual stocks.

Conclusion

When central banks indicate that interest rates have reached their peak, markets tend to swiftly adjust in anticipation of future rate cuts. However, forecasting the exact timing, pace, and duration of a rate-cutting cycle can be very challenging. Lowering interest rates is not just a technical policy decision but, a deliberate strategy aimed at stimulating economic growth. For both individuals and investors, this presents a set of opportunities and risks. By staying informed and adapting investment strategies, you can identify and capitalize on the changing market conditions. Should you wish to discuss your cross-border investment strategy, please reach out to schedule a consultation.