Interest rates are finally being cut across developed markets. The European Central Bank met today and cut rates by 0.25% to 3.5%. The Federal Reserve is expected to cut US rates by the same amount, or maybe double, next week. And the Bank of England meets in a week’s time to consider the same question. It’s likely further cuts will follow before the year is out. What will falling interest rates mean for your investments?

Why are interest rates being cut?

Central banks reduce interest rates for two main reasons. One is helpful to investors, the other less so. In this case, it looks like a combination of both factors is prompting central bankers to act.

The main reason rates are being brought back now is that the battle against inflation is substantially won, for the time being at least.  It’s only a year since consumer price inflation in Ireland was 6.4%. Now it’s just over 2% – a much more comfortable level for consumers, workers and businesses alike.

The second reason for falling interest rates is less welcome: rising recession risk. That’s particularly the case in Europe, with big industrials like Volkswagen discussing factory closures in its home market of Germany, for example.

What’s the impact of falling interest rates?

The immediate effect of global rate cuts will be seen in cash savings.  Ireland’s long-suffering cash savers – who never enjoyed a huge bounce from higher interest rates – will likely see rates on deposit accounts decline.

On the positive side, the cost of debt will fall.  That could provide some help to the global property market. But again, the effect in Ireland is likely to be more muted as banks held down rates on both mortgages and deposits despite ECB policy.

How will the stock market react to interest rate reductions?

The stock market’s reaction to rate cuts will be less uniform.  In general, returns from equities have historically been higher in rate-falling periods.  There are a several reasons for this.  Firstly, in a world where there is little return to be had in bank deposits, investors are more motivated to invest in risk assets (ie those that can go up and down in value) in order to gain a return over the medium term.

Put simply, shares are relatively more attractive when interest rates are closer to 2.5% than 4.0% (where they peaked in the Eurozone earlier this year).

There’s also the fact that companies will be able to borrow more cheaply, which tends to increase their profits.

On the other hand, if rates are being cut to support a slowing economy, that creates a headwind for listed businesses.

Lastly, certain sectors will gain more from lower rates than others.  Technology shares for example, which promise high growth and cashflows over the long term, will gain favour, as their future cashflows become more valuable.

But others will fare less well – for example, the falling cost of debt creates a less favourable environment for banks.

What’s the impact on bonds?

Lastly, bond markets will also see repricing as rates are cut.  In general, in a rate-cutting environment, bond yields will fall and therefore the prices of bonds will rise in the short term. Over the longer-term, because the yield available on bonds is lower, returns will be less attractive to investors.

If you have been holding bonds in anticipation of coming rate cuts, you’ll want to review this position now that reductions are well underway.

What should investors do as rates fall?

Interest rate cuts have been anticipated for some months now, as inflation has gradually been tamed in western markets. So much of the change in rates is baked in to fund investment strategies and prices. But some investors will want to assess their portfolios in light of falling interest rates.

In particular, if you have been enjoying a return on cash on deposit, or in money market funds, you may now wish to move some of that cash into risk assets to maintain the possibility of growth. Investors in government bonds, particularly Irish government bonds, may feel the same way.

It remains to be seen how far and how fast rates will be cut from here.  Reducing inflation has taken longer than many central bankers expected, and while it’s unlikely we’ll see rate rises from here, the path to bringing rates down may be quite drawn out.

Regardless, a rate cutting environment will lead to repricing of assets, making now a sensible time for many investors to review their portfolios.