The Bank of England cut interest rates on 1 August for the first time in four years.

Interest rates now stand at 5%. They were previously 5.25%, a level they reached in August 2023 following 14 consecutive interest rate increases¹.

But how could the interest rate cut affect your portfolio? Read on to find out about the relationship between interest rates and investments and what it means for you.

Why do interest rates matter?

Essentially, interest rates represent the cost of borrowing money, which can influence economic activity as well as the price of certain types of investments. Interest rates can also offer useful insights into the overall health of the economy.

Interest rate cuts or hikes are often predicted well in advance, so they’re usually already factored into the price of investments. As a result, changes in interest rate expectations tend to have a greater impact. US interest rate expectations tend to matter the most – at least when it comes to global investment portfolios, because the US share and bond markets are the largest.

How do interest rates affect bonds?

Bonds are a type of loan issued by governments or companies. They typically pay a fixed amount of interest and return the capital at the end of the term. 

Bonds generally perform well when interest rates are falling. When rates fall, the interest (or ‘yield’) from existing bonds looks more attractive compared to new bonds that offer less interest. This can make the price of existing bonds go up.

When interest rates are rising, investors will often demand higher rates from bonds. Since the interest paid by bonds is fixed, the only way for this to happen is for the price of bonds to fall. Bond prices and yields are ‘inversely related’ – when the price falls the yield rises, and when the price rises the yield falls.

How do interest rates affect shares?

Shares aren’t directly affected by interest-rate changes, but they can be sensitive to them. In theory, falling interest rates can be good news for shares. Lower interest rates make it cheaper for companies to borrow money. This can help them grow and, in turn, boost their earnings. If mortgage rates come down, consumers may spend more money, which also benefits the companies they buy goods and services from.

On the flipside, in a high interest-rate environment, borrowing becomes more expensive. That means companies are less likely to take out loans and spend money. Consumers may rein in their spending, which can hamper companies’ sales.

Changes in interest rates affect different types of companies (or ‘sectors’) in different ways. For example, if interest rates are expected to fall, this may have a positive impact on the technology sector. The attraction of tech companies is the chance for higher earnings in the future compared to what they earn now. These future earnings seem more valuable when interest rates are low because investors can’t earn as much from other investments like cash and bonds.

In contrast, banks may benefit from higher interest rates. This is because they can earn more from the interest they charge on loans versus the interest they pay on cash savings.

In reality, the way different sectors respond to interest rates isn’t always clear-cut. It’s one of the many reasons to hold a balanced portfolio that spreads your money across different sectors (more on that below).

Are interest rate cuts always good news?

It might seem like rate cuts are good news and rate hikes are bad news. But things aren’t quite as straightforward.

Often, the reasons behind an interest rate change are more important than the change itself. The rate cut on 1 August was in response to encouraging news on inflation. But previous rate cuts have been in response to things like the global financial crisis and Covid-19 pandemic, when the economy was under severe stress. In those instances, rates were cut to historic lows in an attempt to bolster the economy.

Read our economist’s views on the August rate cut and the outlook for investors.

What does it mean for my portfolio?

Ultimately, the economy will go through different interest-rate cycles. Sometimes rates will be rising and sometimes they will be falling. Basing your investment decisions on interest rates alone is unlikely to be a wise move. After all, interest rates are just one factor driving investment performance.

Trying to time the market in response to changes in interest rate expectations could prove costly. Even very experienced investors struggle to time the market correctly. You could run the risk of missing out on strong performance and/or locking in losses, which could hamper your long-term investment success.

We think it’s better to tune out the noise and maintain a balanced portfolio – one that contains the right mix of shares and bonds for you and which spreads your money across different regions and sectors. By sticking to your investment plan and maintaining a long-term outlook, you can keep progressing towards your financial goals.
 

¹ Bank of England – Official Bank Rate history.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Important information

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This article is designed for use by, and is directed only at persons resident in the UK.

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