Here’s how I think stocks and bonds will fare if the base rate rises

Bus waiting in front of the London Stock Exchange on a sunny day.

On 4 November, the eyes of the UK economy will be focused on the Bank of England’s Monetary Policy Committee. That’s because nine of its members will make a decision on whether to raise the central bank’s base rate.

Unlike in previous meetings, expectations are mounting that the committee will vote in favour of a rise. So, what would a base rate rise mean for investors? Here’s what I think.

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How does the base rate impact the UK economy?

The Bank of England’s base rate is hugely important. That’s because it sets the rate at which banks can lend to one another and, as a result, indirectly determines interest rates for mortgages, savings and loans.

Take a look at the available credit card deals over the past few months and you’ll have seen an abundance of 0% deals. It’s a similar story for mortgages and loans, where deals have sat at rock-bottom rates for nearly two years.

For savers, however, things haven’t been quite as rosy, with pretty much all savings accounts paying pitiful interest rates.

This current environment is all down to the Bank of England’s base rate sitting at an all-time low of 0.1%. 

Yet fears of rising inflation are now mounting. To combat this, the Bank of England is under pressure to up its base rate. If it happens, then borrowing costs will rise for businesses and consumers, potentially putting an end to the era of cheap credit.

The theory goes that by raising the base rate and making borrowing more expensive, individuals and businesses will be less eager to borrow, and will therefore cut back on spending. This should cool inflation.

What impact would a base rate rise have on stocks and bonds?

If the base rate rises I would expect bond prices to fall. That’s because a rising base rate will almost certainly have a positive impact on savings rates. This means that investors will start to demand higher returns for holding bonds due to the increased risk they have over normal savings accounts. As a result, bond prices should decrease in this scenario.

The impact on stocks and shares is far more difficult to predict. On the face of it, it almost seems obvious that a base rate rise should lower stock values due to the fact that it makes business borrowing more expensive, and therefore leads to a cut in investment.

Yet when the Bank of England upped its base rate in November 2017 (from 0.25% to 0.5%), the FTSE 100 remained steady, and actually rose in value by the end of the year.

In contrast, the last time the Bank of England upped its base rate in August 2018 (from 0.5% to 0.75%) the share index slumped, losing over 1,000 points by December of that year. 

So, when it comes to stock prices, it’s fair to say that it’s unclear how the markets will react to any base rate rise. 

Despite this, it is worth knowing that the stock market often ‘prices in’ rate rises in line with market expectations. As a result, the stock market may not necessarily swing a great deal following any interest rate rise announcement. 

With this in mind, however, the FTSE 100 has remained relatively stable over the past week. This suggests the market isn’t particularly fearful of any impending rise.

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What’s the likelihood of the base rate rising on Thursday?

The Bank of England’s Monetary Policy Committee is responsible for meeting the government’s 2% inflation target in a way that ‘helps to sustain growth and employment’. As a result, many feel that now is the right time for the bank to raise its base rate to ward off rising inflation.

Despite this, it’s worth recognising that neither the European Central Bank nor the US Federal Reserve has raised its own interest rates. Because of this, the Bank of England may feel it can get away with keeping its ua-low base rate for a while longer.

In September, the Bank’s committee voted seven members to two to keep the base rate at its current level. Therefore, at least three of its members will need to be convinced that Thursday presents the right time to act. 

The post Here’s how I think stocks and bonds will fare if the base rate rises appeared first on The Motley Fool UK.

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