Bond Watch: US starts rate-cutting journey with a bang

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.       

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.            

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Interest rates finally fall in America... 

The US Federal Reserve finally cut interest rates, after raising them to a range of 5.25% to 5.5% to fight inflation, on grounds that the economy is weakening and in need of a boost. 

It began with a bumper 0.5 percentage point cut, surprising many investors that expected an initial 0.25 point move. 

The market reaction was mixed, with US bond yields relatively flat but equities rallying strongly, taking the S&P 500 to a new all-time high in dollar terms. In sterling terms, it is still about 2% below its high as a result of a rising pound this year against the dollar.  

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Bryn Jones, head of fixed income at Rathbones, said investors went into this Federal Reserve meeting with the most uncertainty about a rate decision in about 15 years. 

After the result, Jones said: “Inflation still remains, excess savings are still just at trend, and despite an uptick in unemployment, it is still low, but the Federal Reserve obviously felt it’s time to cut by 50 basis points.” 

His view is that a recession is likely in America as a result of this sustained period of higher interest rates, but the timing is uncertain. A recession would generally be good news for bonds, particularly government bonds, but bad news for stocks.  

“Generally, whenever rates go up, recessions do eventually occur, but the timing of those recessions can be anywhere between one year and several years after the first interest rate hike. It seems to be that the Federal Reserve is worried about the probability of this happening now - or is this a pre-emptive strike to keep the economy close to full employment,” Jones asked.  

...but the Bank of England holds steady

The Bank of England moved earlier than its US peer in cutting interest rates, taking its Base Rate down 0.25 percentage points to 5% in August.  

But this week it decided to hit pause, even as inflation figures showed that prices rose 2.2% in the year to August, which is just ahead of the 2% target.  

This should set up the Bank of England to cut interest rates further this year. Not only is it likely to take its cue from the US central bank, but economic data supports more interest rate cuts.  

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Gabriella Dickens, an economist at AXA Investment Managers, says: “We think a further 0.25 percentage point cut in November is in keeping with the messaging that a ‘gradual pace’ of tightening seems appropriate.” 

She believes that there could be a deterioration in the economy over the next 12 months, partly due to tax rises in the 30 October Autumn Budget.  

Dickens thinks that the UK interest rate will hit 4.75% at the end of this year and then 3.75% by the end of 2025.  

Deutsche Bank also expects one more interest rate cut this year, followed by four next year, and then another three in 2026, taking interest rates to 3%.