How does the rate cut affect my investments?

The European Central Bank (ECB) decided to cut interest rates by 25 basis points, from 4.5% to 4.25%, in line with what it had stated at previous meetings and also following market expectations. However, the possibility of this move being the start of a cycle of rate cuts in Europe seems to be receding after this month’s meeting.

In its statement, the ECB insisted on its 'data dependent' approach, which effectively means it will continue to take decisions in line with macroeconomic data. This is the first rate cut in eight years after an aggressive hike from 2022 to tackle inflation, which is still some way off the 2% target rate. In fact, the eurozone CPI has just faced its first bumps both in the general rate and in the core rate. “These increases are driven by service dynamics, combined with a lees clear deflation in energy and goods, despite the recent drop in oil prices,” said Eduardo Garcia, senior economist at MAPFRE Economics.

As for growth, the outlook has improved and the rebound expected for the second half of the year seems to have been brought forward, encouraged by more expansive PMIs and consumption that’s painting “an increasingly healthy picture thanks to the wage space gained after the latest negotiations,” García notes.

This improvement in expectations, together with the upturn in inflation in May, may indicate that this rate cut isn’t justified from a macroeconomic point of view. "The macro situation in Europe doesn’t justify rate cuts, certainly not a cycle of them. We have growth, albeit weak, and it’s starting to improve. There are other nuances, such as financial stability, but from the macro data, it’s not justified,” says Alberto Matellán, chief economist at MAPFRE Inversión.

The current estimates for 2024 predict two or three interest rate cuts, which would bring them back down to just above 3%. “This is significant because it follows a period of exceptionally low (or even negative) interest rates, and the key point to understand is that rates will stay positive and won’t return to those levels we saw in the past. This new scenario marks a paradigm shift, where fixed-income managers will have some material to work with”, says Ignacio Amo, fund selector at MAPFRE Gestión Patrimonial.

With this rate cut, the ECB is taking a “historic step”: Europe has only been ahead of the United States in initiating rate cuts three times in history. “This highlights the importance of analyzing internal and external factors, even more so when considering the multipolar gap that continues to open up in the world,” explains García.

How will lower interest rates affect my investments?

Ignacio Amo, MAPFRE Gestión Patrimonial’s fund selector, explains it’s still quite difficult to determine the best time to inject duration to portfolios. “Delegating a good portion of the fixed-income portfolio components to active and flexible managers may be most suitable. They can make use of positions in a variety of assets to achieve an IRR/Term/Risk triangle for debt instruments that’s higher than what could be created by selecting a specific asset type”, he points out.

This new market paradigm in Europe, where interest rates are falling but still positive, is creating opportunities across the entire fixed-income spectrum.

• The shortest segments of the yield curve lose attractiveness

Once a period of rate cuts has been confirmed in Europe, we could see a process of yield curve steepening that would favor higher IRRs or yields on longer segments, with shorter segments becoming somewhat less attractive.

“Investors may now be facing what’s known as inversion risk, where an investor trying to take advantage of the curve’s shorter segments, via products such as treasury bills, could encounter a loss of attractiveness when these products reach maturity, compared to investments with longer terms”, he indicates.

The fund selector adds that even if the shorter segments lose some of their appeal, “we still think it makes sense to maintain positions in those segments, since there are still possibilities to capitalize on their well-known yields”. In his opinion, this is why money market funds and short-term fixed-income securities can remain attractive in a scenario where diversification, flexibility, and skillful managers make it possible to capitalize on those opportunities.

• Relief for companies: Better outlook for refinancing debt

Companies are faced with the challenge of managing their refinancing cycles. This is why a loosening of some of the monetary policies that were previously so restrictive, and which can make that financing so difficult, will help companies save money on interest servicing and improve cash flow.

This can in turn strengthen their solvency and reduce default risk. “This scenario of positive interest rates will also make it possible for us to differentiate between companies with sound management and strong fundamentals, and those that were merely surviving due to assistance and liquidity provided by the ECB. This is why quality debt could become an option for portfolios”, Amo explains.

However, it's important to pause and reflect at this juncture. We’ll have to think clearly about the reasoning behind any potential interest rate cuts announced by the ECB, and about how the market ends up interpreting them. “If the central bank expects to economy to get worse, this could cause a widening of credit spreads, which is another very relevant component for analysis when considering a move into corporate bonds. In that situation, higher spreads would have a negative effect on credit, even if there is a more competitive IRR for longer terms based on a steepening of the yield curve”, Amo indicates. On the other hand, if rates are being cut because the central banks believe that the battle against inflation is being won, the hypothesis described above becomes more likely, and adding high-quality corporate bonds to a portfolio may become an attractive option.