What if the Bank of England Cuts Rates?

And
next
week’s
Bank
meeting
is
the
last
before
the
upcoming
UK
general
election,
which
has
further
aided
the
case
for
caution.  

As
an
institution,
the
Bank
of
England
is
independent
of
government
policy,
and
has
been
since
1997.
Though
its
aim
is
to
reduce
inflation
to
its
2%
target,
it
must
also
be
wary
of
appearing
to
assist
an
incumbent
government
staking
its
ongoing
electoral
chances
on
lower
inflation
–
and
cheaper
money.

But
the
Bank
of
England,
despite
its
recent
caution,
still
has
the
capacity
to
surprise
the
markets,
and
there
is
disagreement
between
traders
and
economists
about
next
week’s
decision.

Markets
Have
Been
Wrong
on
Rate
Cuts
Before 

Another
reason
to
be
wary
of
the
doves
is
the
BoE’s
own
history
of
wrong-footing
investors. 

Back
in
December
2021,
when
it
was
making
its
initial
efforts
to
contain
an
inflationary
surge
in
the
real
economy,
the
MPC
voted
for
a
0.15
percentage
point
increase
in
the
base
rate
to
0.25%. 

Markets
were
not
expecting
this.
At
the
MPC’s
November
2021
meeting,
committee
members
voted

against
an
increase.
With
the
benefit
of
hindsight,
onlookers
may
now
say
the
BoE
was
slow
off
the
mark
in
attacking
inflation.

Readers
with
longer
memories
may
also
recall
the
infamous
“unreliable
boyfriend”
moniker
given
to
former
BoE
governor
Mark
Carney
–
after
Labour
MP
and
former
Treasury
Select
Committee
member
Pat
McFadden
accused
the
Canadian
financier
of
giving
mixed
signals
to
savers
and
investors
about
the
Bank’s
intentions
in
2014.
Carney
talked
over
many
BoE
meetings
about
the
possibility
of
rate
increases,
but
these
never
materialised.
So-called
“forward
guidance”,
where
the
Bank
signalled
its
future
intentions,
was
quietly
scrapped.

Carney’s
successor,
Andrew
Bailey,
has
been
extremely
careful
to
avoid
such
accusations.
The
current
mantra
for
central
bankers
is
“data
dependency”,
which
means
that
policymakers
are
reactive
to
the
monthly
numbers
on
inflation,
wages,
jobs
and
economic
conditions.

Mortgage
Rates
Remain
High

As
ever,
however,
the
BoE’s
primary
focus
will
be
on
what
is
going
on
in
the
real
economy,
and
here
there
is
still
some
significant
pain.
Prime
minister
Rishi
Sunak
may
be
claiming
credit
from
having
lowered
inflation
to
2.3%,
but
interest
rates
at
5.25%
are
still
making
the
affordability
of
debt
difficult. Mortgages
are
priced
above
this
level
and
credit
cards
and
loans
can
command
APRs
of
around
20%.

On
this,
the
MPC
will
have
one
eye
firmly
on
the
rising
cost
of
mortgage
debt,
and,
in
particular,
the
rising
“effective
interest
rate”
(the
actual
interest
paid)
on
new
mortgages.
In
April
this
increased
by
one
basis
point
to
4.74%,
while
the
rate
on
outstanding
mortgage
loans
increased
by
seven
basis
points
to
3.57%
in
April. 

“Niggling
inflationary
pressures
and
an
impending
general
election
make
an
imminent
interest
rate
cut
less
likely,
but
the
sign
of
lingering
affordability
challenges
for
buyers
was
evident
in
the
effective
rate
on
newly
drawn
mortgages,”
says
Bestinvest
personal
finance
analyst
Alice
Haine. 

“According
to
the
latest
Household
Costs
Index
(HCI)
in
the
year
to
March,
UK
households
with
mortgages
remain
the
hardest
hit
by
inflation
with
costs
up
by
5.5%
compared
to
just
3.3%
for
owner
occupiers.” 

So
while
homeowners
may
already
have
had
some
good
news
in
the
form
of
falling
inflation,
nobody
envies
the
folk
trying
to
remortgage
–
let
alone
those
with
fixed
rate
mortgages
coming
off
1-2%
deals
and
taking
on
6%
variable-rate
mortgages. 

How
Will
Equities
be
Affected?

Markets
tend
to
“price
in”
any
changes
very
quickly,
so
the
reaction
to
this
kind
of
news
will
be
swift. We
saw
this
last
week
with
the
European
Central
Bank’s
decision
to
cut
rates,
which
was
widely
expected
by
markets
–
and
well
flagged
by
policymakers.

As
a
broad
trend,
rate
cuts
that
haven’t
resulted
in
economic
recessions
tend
to
be
followed
by
strong
equity
returns.  

“Looking
at
data
since
the
early
1980s,
the
performance
of
the
S&P
500
over
the
subsequent
12
months
after
the
first
rate
cut
averaged
14.2%,
a
higher
number
compared
to
the
average
12-month
return,”
say
Julius
Baer
head
of
research
Christian
Gattiker,
chief
economist
David
Kohl,
head
of
equity
strategy
Mathieu
Racheter,
and
economist
David
Alexander
Meier.  

“As
such,
rate-cutting
cycles
that
are
not
triggered
or
followed
by
a
recession
tend
to
be
accompanied
by
strong
equity
returns.
That
said,
we
acknowledge
that
each
cycle
is
different.” 

Indeed,
there
are
caveats. 

“This
time
around,
a
lot
of
the
positive
performance
has
been
frontloaded,
and
we
are
still
of
the
view
that
developed
market
equities
are
ripe
for
a
correction,
which
would
be
a
healthy
development,”
they
say. 
“In
the
case
of
a
correction,
we
would
use
the
setback
to
increase
equity
exposure.” 

In
the
case
of
the
UK,
equity
markets
are
already
at
record
highs.
Would
they
go
higher? 

“Would
it
come
as
a
positive
surprise?
Yes.
Would
it
move
markets
materially?
No,”
Field
says. 

“The
FTSE
100
touched
all-time
highs
last
month
and
is
trading
just
below
that
now.
So,
to
a
large
degree
some
macroeconomic
optimism
is
already
built
into
prices.” 

Morningstar
Wealth
associate
portfolio
manager
Nicolo
Bragazza
adds
that,
should
the
BoE
cut,
small-cap
stocks
will
likely
benefit
the
most. 

“Within
equities,
smaller
companies
should
be
among
the
beneficiaries
of
a
rate
cut
as
they
are
more
sensitive
to
the
rate
environment
than
larger
global
players
with
more
reliable
access
to
global
financial
markets,”
he
says. 

“Along
with
smaller
companies,
utilities
tend
to
be
positively
impacted
by
rate
cuts
as
they
are
leveraged
businesses
and
their
attractiveness
depends
also
on
the
spread
between
their
dividend
yield
and
that
on
government
bonds.” 

How
Will
Bonds
be
Affected
by
a
Surprise
Rate
Cut? 

Conventional
wisdom
suggests
rate
cuts
are
better
for
equities
than
bonds.
But
while
bonds
have
returned
to
favour
in
the
higher
interest
rate
era
because
of
their
tempting
yields,
rate
cuts
may
not
be
bad
for
them
either. 

Falling
interest
rates
mean
lower
yields,
which
push
bond
prices
higher
–
a
key
factor
in
total
returns.
And
lower
rates
make
existing
bonds,
and
particularly
those
already
issued
during
a
period
of
rate
hikes,
more
attractive
for
yield.
UK
government
10-year
gilts
currently
yield
more
than
4%,
which
is
below
base
rate
but
above
inflation.
Yields
have
dropped
back
over
a
one
month
and
one
year
period
as
markets
anticipate
interest
rate
cuts
this
year
as
inflation
falls.

In
addition,
many
pension
funds,
for
whom
rising
yields
have
caused
havoc,
could
also
stand
to
benefit
from
a
looser
monetary
approach.
This
is
where
the
specifics
really
matter,
Bragazza
says. 

“As
a
general
rule,
lower
yields
imply
higher
bond
prices,
and
this
is
because
future
cash
flows
are
discounted
at
a
lower
yield
–
thereby
increasing
their
value,”
he
says. 

“However,
the
extent
to
which
a
cut
will
move
bond
prices
not
only
depends
on
the
size
of
the
rate
cut
but
also
by
how
much
that
rate
cut
is
already
priced
in
by
the
market.” 

Given
markets
are
not
currently
expecting
a
rate
cut
at
all,
bond
investors
will
likely
be
caught
off
guard,
and
that
will
probably
have
a
more
immediate
impact. 

“Currently,
the
market
is
not
pricing
a
high
probability
of
a
cut
by
the
BoE
so
any
cut
would
be
a
surprise.
Surprise
rate
cut
have
generally
a
stronger
immediate
impact
on
markets,
and,
generally,
we
can
expect
these
to
be
positive
news
for
both
bonds
and
equities
as
they
should
reduce
the
discount
rate,”
Bragazza
says. 

What
Should
Investors
Do? 

In
an
ideal
world,
the
BoE’s
first
rate
cut
of
the
cycle
presents
a
clear
case
for
being
invested
in
both
equities
and
bonds.
While
rates
may
be
cut
this
summer,
they
remain
in
the
lingo
“restrictive”,
ie
high
in
comparison
with
period
since
the
financial
crisis.

Amid
some
significant
uncertainty,
a
well-diversified
portfolio
will
stand
investors
in
good
stead
in
the
long
term. 

“Although
rate
cuts
are
usually
a
positive
signal
for
the
markets,
the
guidance
provided
by
the
central
bank
is
equally
important
and
the
motivations
behind
a
decision
and
the
path
ahead
are
as
important
as
the
rate
cut
itself,”
says
Bragazza.  

Even
if
a
rate
cut
is
a
question
of
when,
not
if,
then,
it
still
pays
to
keep
an
eye
on
the
detail. 

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