Interest Rates Are About To Start Falling – What Happens Next?

Tom Clinch

ECB President Christine Lagarde gathers her governing council for a retreat in Kilkenny this week before their next official meeting on 6th June. She has strongly indicated that euro interest rates will be cut on 6th June if not soon after. If this happens, it will herald a significant inflexion point after a sharp series of hikes from zero in July 2022 to 4% in September 2023. What will this mean for Irish personal finances and the markets?

In the textbooks, Central Banks typically reduce interest rates when the economy needs a boost after a period of recession, unemployment or falling asset prices. In March however, Madame Lagarde said that she was watching the data for “confirmation of what we are beginning to see, which is moderation on the wage front and an absorption of those higher wage costs by the profit margins”. This comment reveals a curious feature of the recent rate hike cycle. Wages have been rising, unemployment has stayed low and recession has been the dog that didn’t bark, in Ireland at any rate.

Could it be that we are finally seeing the end of the neoliberal economic era begun by Reagan and Thatcher around 1980, that started with higher interest rates that created unemployment to crush inflation, and has been characterised by increased globalisation, lower taxes, greater corporate profits as a share of GDP, and stagnant real wages? My sense is that there is a subtle shift underway in this balance of power between capital and labour, which has profound implications if it proves durable.

Witness the inability of employers to roll back the WFH phenomenon in a tight labour market. Christine Lagarde’s comment also confirms that wages have kept rising and profit margins have absorbed some of the extra cost. Furthermore, governments in Ireland, the USA and elsewhere have increased social spending while setting a new minimum corporate tax rate. Despite the economic orthodoxy, inflation fell anyway. How did this happen?

Much of the inflationary pressure was eased by solving Covid supply-chain bottlenecks and by replacing Russian gas supplies after the onset of war in Ukraine. Consumers were sheltered from higher interest rates by the government largesse of unspent Covid payments. Corporates were eager to keep selling their products and services to these cash-rich consumers and despite the extra business cost of higher interest rates, they were reluctant to shed staff in a tight labour market where they might lose productive workers who might never come back. So, unemployment stayed low, wages kept on rising and profits grew by a little less than they would have otherwise.

Perhaps rising interest rates saved Ireland and the USA from overheating, and we ended up with a Goldilocks economy. Germany however was not so fortunate and the combination of higher interest rates, their huge reliance on Russian gas, and a move away from petrol engine cars did cause a German recession. So now Ireland will get a reduction in ECB interest rates whether it needs it or not. So, what effect will lower interest rates have on Irish personal finances?

We are likely to see lower mortgage rates, increased consumer spending and rising house prices amongst other things. That said, there are several major factors that may limit the fall in inflation and interest rates. Greater labour bargaining power, reduced globalisation and the green transition are all inflationary. So, nobody is predicting a return to zero euro interest rates. How will this affect the markets?

10-year EU sovereign bond yields are hovering around 3%. Investment-grade euro corporate 5-year bond yields are currently around 4%. This implies a modest reduction in ECB rates to something around 2% and if this pans out, we will have bond yields providing an attractive real return over inflation for the first time in almost two decades.

Global equities grew by c. 20% in 2023 and another 12% year-to-date in 2024. So, they hardly need a further boost and may have already priced in most of the projected gains from lower interest rates. Despite this, market forecasters are projecting further gains when interest rates start to come down. Given the long-term economic trends discussed above, equity returns should only be moderately above bonds in the long run. So, investors should watch out for an AI bubble and be ready to adjust their asset allocation. It would be better for most long-term investors if stock prices stabilised, and price-to-earnings ratios settled back to normal as corporate profits grow, but volatility is a natural feature of equity investing.

One asset class that is overdue a boost from lower interest rates is commercial property. Despite what we read in the press, there has been no dramatic crash in Irish commercial property funds. The benchmark Aviva Irish Property Fund is stable year-to-date in 2024. There are major trends disrupting this sector, but values will reach a new equilibrium eventually and they are typically boosted by falling interest rates. More on that in our Autumn letter. In the meantime, enjoy the Summer.

 

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