This week in the markets: all about interest rates

No doubt what the main story will be this week. It’s all about interest rates, with decisions due in the US, UK and Japan.

Will the Fed go large?

The main question this week is not whether the Federal Reserve will cut rates but by how much. After holding fire for much longer than investors expected - or hoped - the Fed must now decide whether it has sat on its hands for too long. With signs of a slowing economy, it is almost certain to cut rates by at least a quarter percentage point on Wednesday - but there’s still a good chance it will opt instead to front load the easing cycle with a jumbo half point cut this week.

There’s a good case to be made for rate cuts. Standing at a 23-year high of between 5.25% and 5.5%, US interest rate are starting to have their desired effect. Job creation is slowing and inflation heading back to target.

Over here, it’s a similar story and the Bank of England has already started to cut the cost of borrowing. However, it is by no means a given that it will follow through on Thursday with a second consecutive cut. Core inflation remains above target, unemployment remains low and economic growth has been stronger than expected. The consensus is for a hold this week and a second cut in November.

That just leaves Japan, which is marching to a different beat. Having raised rates for the first time in more than a decade in July, from zero to just 0.25%, the question is whether the Bank of Japan follows through with another hike on Friday. Again, the smart money is on no change. Although wage inflation is trending higher, prices are not an issue in Japan after decades of deflation.

Where does that leave markets?

We are now almost two years into the latest cyclical bull market. The S&P 500 has risen 62% since it bottomed out in October 2022 from an interest-rate-fuelled swoon. That’s a good performance but not out of line with previous bull markets. Investors are in a sweet spot - financial conditions are favourable, company earnings are rising and the cost of capital is coming down. It’s an attractive set up for the markets.

Here, too, although the FTSE 100 has drifted over the summer, it is not far off its all-time high. That’s despite seriously underperforming the US market in recent years. Since the bottom of the market two years ago, the S&P 500 has risen more than 40% while the FTSE 100 is up just 12%.

What’s interesting is not the headline level of the market but what’s doing well and badly beneath the surface. Over the past couple of months, it’s been defensive stocks - especially consumer staples like Kraft, Procter & Gamble, Coca Cola and Colgate Palmolive - which have picked up the baton from the flagging mega cap technology stocks.

Defensive stocks often do well ahead of the first interest rate cut as investors brace themselves for tougher times ahead. That, after all, is why monetary policy is starting to ease. And this is precisely the backdrop investors are looking at today.

Gold retains its lustre

Meanwhile, one of the best performing assets of the year to date has been gold, which last week hit a new high of $2,575 an ounce. It has risen by nearly 30% since February. Gold is a safe haven in times of economic trouble, but even when things are looking more promising it can be a store of value if investors are worried about fiscal and monetary policy. With tax spending high, and interest rates falling even as the economy continues to grow, there are good reasons for investors to appreciate the inflation-hedging qualities of the precious metal.

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