Interest rates don’t make the most riveting topic of conversation – but that doesn’t stop us talking about them, especially when they change. The impact that the Bank of England (BoE) base rate has on our finances is far-reaching – probably more so than many realise – and any changes to the rate is big news.
So, the Bank’s decision to reduce interest rates once again in May – cutting them from 4.5% to 4.25%, down from 5.25% last summer – made headlines. When interest rates go up, loans (including mortgages) become more expensive, but savers get better returns on their savings accounts. So, while rates falling again isn’t great news for savers, it’s a relief for many borrowers (especially mortgage borrowers on deals that track the Bank’s rate). Mortgage lenders have already cut rates in 2025 and further reductions are expected over the coming weeks and months.
But what about the impact on investments, including those held in pensions and Individual Savings Accounts (ISAs)? Let’s look at how interest rates affect the financial markets and therefore your investments.
Why does the Bank of England change rates?
The Bank of England and other central banks use interest rates to help the economy, either by heating it up or cooling it down. The latest cut was due to slower inflation and the effects of the US trade tariffs on the global economy, said the Bank. Low interest rates keep the cost of borrowing down and galvanise economic growth because companies are more likely to borrow when loans are cheaper.
Lower rates also make it cheaper for consumers to spend on credit – so personal consumption (particularly of high-value items like cars and houses) should tick up too. If an economy seems to be faltering, low interest rates can prop it up on two fronts. It’s the classic supply and demand scenario. When the economy is growing rapidly and demand for goods and services exceeds supply, businesses can increase their prices, creating inflationary pressure.
How do interest rates affect bond prices?
When investors buy government bonds they’re essentially lending the government money at the current interest rate. If interest rates go up, investors will want to dump existing bonds with the lower interest rate to buy the ones paying the new, higher rate of interest. As a result, bonds that are currently in the market go down in price when interest rates go up.
Short-term government bonds are a type of low-risk loan and therefore closely mirror base rate movements. When the base rate rises, the price of existing bonds will fall until the yield (which is their interest rate as expressed as a percentage of their price), is similarly high – which means the price of the bond can drop significantly. The price of long duration bonds will be less affected but can still change, especially if the BoE has given its views on the direction of travel.
Because the UK is viewed as a safe bet (as it’s highly unlikely to fail to reimburse investors), the price on riskier bonds will also move. No one’s going to take on more risk unless it’s rewarded by higher returns – so higher government interest rates also force existing corporate bonds (or dodgy countries’ government bonds) prices down until their yields are on a par.
How do interest rates affect the stock markets?
The impact of interest rates on bonds is clear and evident, but the impact on stock markets is less so. Overall, low interest rates are good for businesses because cheaper financing options allow them to expand and invest in their businesses, operations and workforce. It’s a goldilocks scenario though: not too high and not too low – if the BoE slashes rates to avoid a recession or boost the economy, investors can also get nervous about company prospects and sell off stocks.
How interest rates affect currencies
In today’s global economy, investors can put their money in more or less any country they choose. That means economies compete when it comes to interest rates. If the US has interest rates of 1% while the UK’s paying 5%, it won’t make sense to invest in US bonds: as you could get a much better return in the UK without taking on much more risk, as neither government is likely to default. Smart investors will therefore buy the British pounds necessary to buy British bonds. And that demand for the currency means the pound will increase in value.
But if only it were that simple! If a country has high interest rates and persistently high inflation, investors might be worried about the value of their cash getting eroded over time and decide not to place their money there, which would devalue the currency.
How should you invest when inflation and interest rates are falling?
Broadly speaking, lower borrowing costs for businesses and consumers tends to boost economic activity. This is helpful for investors, as returns are generally higher when interest rates are low and it’s easier for firms to pay dividends to shareholders. Here are some tips for how to invest in this climate:
Invest in consumer-focused companies
Companies that need consumers to spend money should benefit from the effect of reducing borrowing costs on individuals. Lower interest rates also reflect lower inflation, potentially creating more disposable income for some people. So, companies such as retailers, housebuilders, restaurants, hotels and airlines are well placed to do well when consumers are able to spend more.
Give commercial property a look
Commercial property tends to perform more strongly in a falling interest rate environment, as both consumers and companies are able to take on more debt to buy property and mortgages gradually become more affordable again. Infrastructure companies gain for similar reasons, as well as the fact that they benefit from reduced competition from cash and government bonds when interest rates are lower.
Invest in growth stocks
While value stocks – companies trading below their intrinsic value – tend to do well when inflation and interest rates rise, a lower interest rate environment favours growth stocks. These are companies that have opportunities to increase their earnings and dividends, even if the share price is high. Such companies often require a lot of capital to fund business expansion, and lower interest rates make that capital (i.e. loans) cheaper and easier to come by.
Government and corporate bonds
These benefit from interest rates being low, as the interest rates they offer look more attractive compared with other assets. While higher interest rates suggest to investors that there are greater risks ahead for the economy, further reducing the appeal of investing in company debt, lower interest rates should – in theory – have the effect of boosting confidence in the economy. You would expect bond yields to fall and bond prices to go up as interest rates continue to come down.
Diversify your portfolio
It is important to diversify your portfolio across different asset classes and sectors. This will help to reduce your risk if one asset class or sector underperforms. While interest rates and inflation are a big influence on investment performance, companies and sectors are also impacted by other micro- and macroeconomic factors. In addition to the asset classes mentioned above, you could also consider investing in stocks of companies that are well-positioned to benefit from long-term trends, such as technology and healthcare.
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