Impact of the ECB rate cut of 0.25% on different financial assets and their relationship with the different inbestMe Portfolios

Interest rate movements always cause some uncertainty in savers and investors, and the recent 0.25% rate cut by the European Central Bank (ECB) will not be an exception. This change in monetary policy will have different effects on various types of assets. Next, we analyze the theoretical impact of a rate drop on the main financial assets and how they relate to the portfolios offered by inbestMe.

Theoretical impact of a drop in interest rates on different financial assets

Let’s review what the theory says about the impact of a rate cut on the major asset classes.

Deposits

As we have already observed, banks in Spain have not waited and have already started to reduce the remuneration of deposits. With the recent drop in official rates, it is likely that banks will continue to lower these remunerations. However, there could be banks that take advantage of this situation to start a “deposit war”.

Treasury Bills

In the case of Treasury bills, a drop in rates means that new issues will offer lower yields. This may make these assets less attractive as investors look for alternatives with better yields. Remember that in general our savings portfolios, our target portfolios, or our bond portfolios are more efficient options.

Monetary funds

In the case of money market funds, a drop in rates implies a drop in yield. However, unlike fixed income (which has a duration, however short it may be), since it has no duration, its effect on the price is practically nil. Money market funds will simply continue to accumulate yield, but after the 0.25% drop, they will accumulate yield at a slower rate. This decline will start to become evident in the coming days. See below for information on the impact on the IRR of the Euro Savings Portfolio.

Fixed Income and Bonds

Generally speaking, when interest rates go down, bond prices go up. This is due to bond dynamics, and in particular the inverse relationship between interest rates and bond prices. As newly issued bonds have lower interest rates, bonds in the market become more attractive and their price rises. The impact on bond prices is actually somewhat more complex. On the one hand, the impact is different depending on the duration of the bonds. On the other hand, short-duration bonds are more influenced by central bank decisions, while for long-duration bonds, movements in the yield curve are more important.

Equities or stocks

Equities can benefit from lower rates because companies can finance themselves at lower costs, potentially increasing their profits and thus the valuation of their shares. Additionally, future flows are discounted at lower rates, increasing the stock price. However, this depends largely on market expectations and whether companies manage to meet these new adjusted expectations.

Currencies

A rate cut by the ECB may lead to a depreciation of the euro against other currencies, such as the dollar. This effect may be temporary, as it is likely that the Fed will also have to lower rates soon. Moreover, the fluctuation depends on many other factors.

From a macroeconomic point of view, a rate cut stimulates the economy. Although economic theory suggests certain effects of a rate cut on different financial assets, it is significant to remember that these relationships are not guaranteed. Moreover, some of these relationships may already be anticipated by the financial markets (e.g., equity rises in recent months).

The level of interest rates is just one of many variables that affect markets. Factors such as inflation, fiscal policy, global economic conditions and market expectations also play a crucial role, as well as unexpected crises or black swans.

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Interest rate declines and relationship with inbestMe’s portfolio rates

Savings Portfolios

The inbestMe Euro Savings Portfolio, which includes money market funds, will reduce the Internal Rate of Return or IRR (variable) due to the rate cut. It is to be expected that if the ECB has reduced 0.25% in mid-June, we will announce a decrease in the variable IRR of our Euro Savings Portfolio to around 3.25%. In any case, as long as interest rates are clearly positive, our Savings Portfolio will continue to give a positive return. Let us remember that the money market funds we use have practically no duration and, therefore, the fall in rates has practically no effect on the prices of the assets within the money market fund.

Important note: calculation by subtracting 0.25% from the current IRRs. This is an estimate to be confirmed in the next few days.

Our savings portfolio continues to be one of the best alternatives for immediate savings. Perhaps the most relevant thing to highlight is that the difference in profitability has always benefited the Savings Portfolio, staying on average around +1 percentage point above the remuneration of deposits. In addition, these portfolios are designed to provide liquidity and almost zero volatility, so they will continue to be one of the best options for your emergency fund and the remuneration differential will probably continue.

Note: the Dollar Savings Portfolio is not affected and continues to maintain an IRR (variable) of 5%. It is possible that soon the FED will also lower its official benchmark rates by 0.25%.

Target Portfolios

Target portfolios are designed to achieve specific short and medium-term financial goals. Exposure to short-term, time-bound fixed income makes them a very interesting option in this environment. In addition, by their nature, having a target return at a target date makes them an excellent vehicle in a possible downward rate environment and can lock in a now very attractive cumulative return. Investors who hold their target portfolio to maturity will continue to receive their target return without being negatively impacted by fluctuations in interest rates.

Bond Portfolios

In Bond Portfolios, as we have seen above, a drop in rates is favorable, as it will increase the value of existing bonds. The cautious bond portfolio is less sensitive to changes in interest rates while the aggressive portfolio could benefit more, although the aggressive portfolio has more volatility (hence the name).

Index Fund Portfolios

Index Fund Portfolios (or ETFs) are designed for the medium to long term and are highly diversified. A drop in rates can have a positive impact on the fixed income portion of these portfolios and potentially on equities. But in general they will have more volatility and risk (higher in the risk profile) than the previous portfolios, although diversification helps to mitigate it. Over long horizons, what happens in the short term with interest rates has very little impact on the long term.

Pension Plan Portfolios

Pension Plan portfolios are also designed (except for the 0 profile) for the medium to long term and are highly diversified. A drop in rates can also have a positive impact on the fixed income portion of these portfolios and potentially on equities. The diversification of these plans will help mitigate the risks associated with changes in interest rates. In general, for younger non-retirees with many years ahead of them, what happens in the short term with interest rates has very little impact on the long term.

Focus on what you control to achieve financial success

At inbestMe in general we recommend being very little aware of what happens in the markets, in interest rates and in all other variables that may influence the short-term evolution. In addition, we are aware that beyond the theoretical relationships that we discussed at the beginning, it is very difficult to predict what will actually happen. We have said above that a rise in interest rates discourages growth and can generate a recession: the announced recession of 2023 never occurred.

Therefore, we recommend focusing on what we control, our savings capacity and our financial objectives. The segmentation of our financial objectives and portfolio diversification are fundamental to manage volatility and maximize the opportunities to achieve them and to grow our wealth in different economic scenarios.

At inbestMe, our portfolios — Savings, Target, Bonds, Index Funds (or ETFs) and Pension Plans — are designed to suit a variety of needs and objectives. We recommend combining these portfolios according to your specific needs, allowing you to plan your entire financial life with the peace of mind of being able to cope with market fluctuations, offering long-term stability and growth.

We also recommend automating the recurring contributions to your different portfolios to go in automatic mode: this way you can forget about being aware of the markets, and you will enter at different market moments.

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