Interest rate cuts aren’t always a cause for celebration if you are an investor. While rate cuts ease pressure on individuals and businesses by lowering borrowing costs, they can also signal that the health of the economy is declining.
For the past three years, investors and economists have been speculating about the likelihood of a “soft landing”. Would central banks be able to raise rates just enough to tackle inflation, before lowering them in time to prevent a recession?
For a while, the picture looked positive. Economies proved surprisingly resilient in the face of higher rates and stock market performance looked good. After a rough year in 2022, the S&P 500 delivered back-to-back returns of more than 20% in 2023 and 2024. Global equities weren’t too far behind.
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Despite this, the picture has become more complex in recent weeks. US president Donald Trump has spooked businesses, households and investors with his erratic tariff regime which threatens to push inflation higher and dampen economic growth.
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While interest rates remain an important consideration for investors as they construct their portfolios, it is impossible to take advantage of the shifting interest rate environment without first considering the latest geopolitical developments.
Firstly, geopolitical developments will influence the speed and extent of rate cuts. Secondly, they will influence what's behind them. In other words, are central bankers cutting rates because inflation has come under control or because growth has become a concern?
These considerations will shape whether investors are bullish or defensive in their approach.
1. Gold
The current interest rate environment could make gold attractive. The gold price tends to rise when interest rates are cut, as gold (which pays no interest) becomes more attractive on a relative basis as the yield on cash falls. The gold price has continued to hit new highs so far this year and is up around 11% year-to-date.
Beyond interest rate considerations, gold bugs will tell you that the yellow metal is always a good thing to have in your portfolio. It holds its value well, meaning it can act as a hedge against inflation. It also has a low correlation with equity markets, which means it offers good diversification potential.
Demand for the asset remains strong, and safe-haven buying could propel it even higher going forward. Physically-backed gold ETFs saw significant inflows in February totalling $9.4 billion, the strongest since March 2022, according to the World Gold Council.
“Recently, Trump's tariffs have increased uncertainty and market volatility, which supports the likelihood of gold being viewed as a safe-haven asset. These factors have traditionally driven investors toward gold as a reliable investment during unstable times,” said Rick Kanda, managing director of The Gold Bullion Company.
See MoneyWeek’s round-up of the best gold ETFs.
2. Bonds
Bond prices tend to rise when interest rates fall, as the coupons on existing bonds start to look more attractive than those on new issues. With further interest rate cuts expected over the course of 2025, the asset class could be worth a look. Yields are still high, meaning a decent level of income is on offer too.
When weighing up which sorts of bonds (or bond funds) to include in your portfolio, there are a range of considerations – from credit quality to duration. As recessionary risks ramp up, investors might want to opt for more creditworthy parts of the market. This could include developed market government bonds or high-quality investment-grade corporate bonds, where the risk of defaults is minimal.
Another reason for opting for more creditworthy bonds in today’s environment is that credit spreads (the premium investors get paid for taking on more credit risk) are currently quite tight. In other words, investors are not being compensated that well for buying riskier bonds.
When it comes to duration, some might make the case for investing in bonds with longer maturities to “lock in” higher interest rates for longer. However, with inflationary pressures heating up again, this approach could come with risks.
“Although longer-dated bonds have high yields which can be locked in, the market volatility of these bonds can result in significant swings in value,” said George Martin, senior fixed income analyst at wealth management firm Charles Stanley. For this reason, he favours shorter duration bonds around the two-to-three-year level.
The longer a bond’s duration, the more sensitive it is to changes in inflation expectations. “Longer-dated bonds therefore carry a higher level of risk, and in a world where inflation doesn’t get back to the central bank's 2% target, investors could see losses, despite the bonds having a high yield on paper,” Martin added.
3. UK dividend stocks
Although bond prices will rise as interest rates fall, the level of income on offer in the bond market will start to come down. The same is true for cash yields. We have already seen a barrage of interest rate cuts in the savings market over the past year. As this takes place, investors who are reliant on income may need to consider increasing their allocation to dividend-paying equities.
The UK market is a fertile ground for dividend stocks. Currently, the FTSE 100 is offering a 12-month forward dividend yield of 3.8%, based on Factset data. The FTSE 350 is slightly higher at 3.9%. This is not too far behind 10-year government bonds, which are yielding 4.7% at the time of writing. Share buyback activity has also risen in the domestic market in recent years, meaning the real cash return investors are getting is higher than the dividend yield would suggest.
“Thus far in 2025, the UK equity market has offered more dividend increases than it has cuts, more share buyback announcements in value terms than at the same stage in 2024, and more positive surprises than negative ones,” said Russ Mould, investment director at platform AJ Bell. “This is all despite what appears to be, on the surface, a gloomy macroeconomic backdrop and a tense geopolitical one.”
If the domestic market continues the year as it started, with strong share price performance, you could also benefit from capital growth. Stock markets around the world have taken a hit in recent days, but the FTSE 100 is still up around 3% year to date. This compares favourably to the S&P 500, which is down almost 5% over the same period.
Alternatively, if the market takes a downturn, dividend stocks could prove a defensive play. The ability to regularly pay a consistent (or rising) dividend to shareholders is often a sign that a company has good financial discipline.
4. If you are more bullish on the growth outlook… small caps
Those who are more optimistic about the economic outlook might want to focus on less defensive areas of the market. For example, if you think recessionary fears are overblown, small cap stocks could be worth a look.
Smaller businesses typically suffer during periods of high inflation and interest rates. It can be more difficult for them to swallow price increases and they are often more leveraged (and more exposed to floating-rate debt) than their larger counterparts. As inflation comes under control and interest rates fall, they can rally.
Research from global investment company Aberdeen, published earlier this month, suggests UK small caps offer particular opportunities, trading at a discount of more than 24% compared to their 10-year average.
That said, it is worth pointing out that they could take a hit from the increased labour costs coming in from April. “Smaller firms may find it harder to adjust to the increased costs brought by the [higher] minimum wage and higher national insurance contributions,” Mould notes.
