What will be the impact of interest rate cuts on capital markets?
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Federal Reserve (Fed) Chairman Jerome Powell announces that the time has come to start cutting interest rates in the US. The move follows data showing that inflation is moderate, with consumer prices rising at an annual rate of 2.5% in July. Interest rates have been at their highest level in two decades since last July.
Equity indices have returned to record levels, reversing the losses seen at the beginning of the month when forecasts of an imminent recession began to spread. Lower interest rates should, in theory, stimulate investment, boost economic growth, and increase the attractiveness of risky investments in equity markets.
The long period of no change in interest rates is coming to an end.
It has been 13 months since the Fed last raised interest rates, the second longest period since the 1970s. The longest period without a change was between June 2006 and September 2007, when 15 months elapsed between the last rate hike and the first rate cut.
Vir: Pexels
What could go wrong with the first US interest rate cut since 2020 and record share and property prices?
With the first US interest rate cut since 2020, coupled with record stock and real estate prices, there are various risks and problems that could arise:
- Increase inflation: interest rate cuts usually stimulate consumption and investment, which can further accelerate inflation.
- Excessive borrowing: Low interest rates can encourage individuals and companies to borrow excessively, which can lead to financial instability.
- Asset market bubbles: Already high share and property prices could inflate further, creating bubbles in these markets.
- Misallocation of capital: Low interest rates can encourage investors to seek higher returns in risky investments.
- Reduced effectiveness of monetary policy: If interest rates are cut too quickly, central banks may not have enough room to manoeuvre in the event of future crises.
- Effect on exchange rates: A cut in interest rates could weaken the dollar, which could affect trade flows and cause instability in currency markets.
- Reduced confidence in the central bank: If investors perceive a cut in interest rates as a sign that the central bank sees more serious economic risks, this could reduce confidence in the central bank’s ability
Vir: Envato
Key implications of the first US interest rate cut for commodities:
- Increase in demand for raw materials: low interest rates can stimulate economic growth, leading to higher demand for raw materials.
- Excessive speculation: With low interest rates, investors may seek more profitable investments in commodities.
- Devaluation of the dollar: Lowering interest rates can weaken the value of the US dollar.
- Disruptions in production chains: If interest rate cuts occur in a context of pre-existing inflationary pressures and high energy costs, this can put additional pressure on production costs.
- Supply-demand mismatch: Interest rate cuts can stimulate investment in commodity production, but with a time lag.
- Downside risk in a recession: Although interest rate cuts usually stimulate economic growth, there may be situations where the economy slows down or enters a recession.
Gold price versus gold ETF fund flows
There has been a significant divergence between the gold price and gold ETF flows in recent times, but a new trend seems to be emerging – ETF flows are becoming positive again and increasing. Simply put… Western investors are increasing their holdings in gold.
The newsletter “Financial insights and trivia” does not constitute an investment advisory service. Its content does not constitute recommendations to buy or offers to buy, but is intended to inform the public about developments in the financial field. Past returns are not a guarantee of future returns. Please consult a financial adviser for advice.