Given the volatile swings in the stock market over the past couple of weeks, it hasn’t been surprising that most investors have been glued to watching the FTSE 100 index. Yet the bond market has been shifting a lot as well. UK Government bond prices give an indication of where people expect interest rates to be later this year. Using that and updated analyst forecasts, there’s a key takeaway for stock investors.
Thinking it all through
Short-term UK Government bond yields have dropped sharply. When I look at UK index swaps, the implied UK interest rate for the end of this year indicates that the market expects four 0.25% rate cuts. This ties in with some analyst expectations I’ve seen. Some looking for three or more rate cuts from the Bank of England committee.
The shift in expectations shouldn’t come as a surprise. It’s because of the recent US tariff announcement. The potential shock that this could cause to both the global economy and the UK economy means that some investors are getting a bit spooked. This is evident from the fall in the FTSE 100 and is also reflected in the bond market.
However, the increased likelihood of sharp rate cuts later this year could act as support in the coming months for the stock market. Lower interest rates help boost economic growth. They provide people with less incentive to save and more to spend. For companies, it means that loans and new debt become cheaper. This can be used to help fuel expansion and new projects. Although it isn’t always the case, cutting interest rates is usually followed by a growth period in the economy and a rising stock market.
A British case study
In order to find stocks for my watchlist, the main criteria here is finding ideas that could benefit the most from a big drop in the base rate. One that is worth investor consideration is Severn Trent (LSE:SVT). The water and wastewater service provider operates mainly in the Midlands and Wales.
Over the past year, the stock has risen 6%. Operations are relatively straightforward, but the company has a high debt load due to infrastructure spending projects. Some might see this as a risk. The latest half-year results showed that net financing costs for debt totalled £124.6m! The revenue for this period was just over £1.2bn, so a good chunk of this went towards servicing the cost of finance.
However, a reduction in the base rate would lower the cost of debt and could boost investor optimism. The improved cash flow may mean some of the money could be used to pay down some borrowings or put towards other growth opportunities.
Further, Severn Trent only operates in the UK. Therefore, it’s not exposed to US tariffs in the same way that more international FTSE 100 companies could be.
If we start to hear more chatter about rate cuts becoming a reality, I think it could act to spark a relief rally in the market, boosting stocks like Severn Trent.
This post was originally published on Motley Fool
