Is it too soon to price in falling interest rates?

Inflation is only slowly ticking down, but markets are already pricing in relatively low interest rates.

Wooden blocks with percentage sign and down arrow, financial recession crisis, interest rate decline, risk management concept
(Image credit: SewcreamStudio)

Markets seem optimistic that the global inflation surge is over. UK inflation has dropped to 7.9%, the lowest for more than a year; US inflation has fallen even more to 3%. 

The trends in Europe have been a little more mixed, but mostly positive: Spain’s rate is now down to 1.9% – a spectacular fall from almost 11% a year ago. 

In response, investors are increasing their bets that central banks will soon be cutting rates, and beginning to rotate back into interest-rate-sensitive sectors. 

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Take real estate investment trusts (Reits), for example. British Land rose 9% on Wednesday and many of its peers posted gains of 6% or more. 

Many US Reits have rallied by 20% or so over the past month, despite plenty of bleak headlines about how working from home is undermining the office market in many city centres.

The implications for valuations

Some of this confidence seems a little early: the picture still seems very uncertain. 

The spike in energy and food last year and the way that they subsequently fell back creates a very favourable year-on-year comparison for prices now, and that makes underlying trends less obvious. 

Bears will point out that core inflation (i.e., inflation minus food and energy) is proving sticky – although it’s worth noting that core inflation does not seem to be a reliable predictor of future inflation, so this may tell us less than a lot of people assume. 

Still, the risks of runaway double-digit inflation are clearly reducing – we’re just not seeing that kind of trend. What’s far from clear is whether we settle back to, say, 2% inflation, or more like 4%. 

After all, many employees have been able to push for pay rises for the first time in years, yet are still seeing real incomes. 

If job markets remain tight – and there aren’t that many signs of weakness yet – it’s hard to see that pressure easing up. 

Wage demands could keep feeding through into steady inflation, regardless of jawboning about “pay restraint” from the Bank of England

This matters relatively little to solid companies from a fundamental perspective: they will mostly be able to pass on costs over the long term. 

If margins shrink a bit, it will be from near record highs and there’s little point in fretting about this, especially since higher wages is good for demand and the economy in the long run. The implications for valuations are greater. 

A 2% medium-term inflation rate might imply that interest rates average about 3%-4%, based on typical trends outside of the high-inflation 1970s and zero-interest 2010s. 

A 5% one might imply 6%-7%. UK ten-year gilt yields are now just over 4%; US ten-year Treasuries are 3.75%. That’s towards the lower end of the spectrum, consistent with around 2%-3% inflation. 

This may yet prove right – but it certainly doesn’t imply valuations of bonds (and, by implication, of other assets) are excessively cheap by historical standards.

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Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.