What might happen to the FTSE 100 when interest rates rise?

A common concern for FTSE 100 investors right now is the potential effect of the Bank of England imposing interest rate hikes in the face of rising inflation.

And there’s a problem with inflation in the UK right now. The government sets the Bank of England’s inflation target at 2%. In simple terms, this means that if your loaf of bread costs £1 today, a year from now it’ll cost £1.02. Or a new car that costs £20,000 now will cost £20,400 next year, and even more the year after. This motivates consumers to spend money, which helps to grow the country’s Gross Domestic Product (GDP).

How far could inflation rise?

But if inflation falls below 2%, the incentive to spend also drops off, which can be harmful to the economy. And if inflation rises too far above the 2% target, the cost of essentials like housing, energy and food become so expensive that disposable income is constricted. And this also hurts the economy.

According to the Office for National Statistics, the Consumer Prices Index rose to 4.2% in October, up from 3.1% in September. Meanwhile, the Bank of England’s Monetary Policy Committee recently decided to maintain the base interest rate at its record low of 0.1%. But pressure is mounting on the nine-member group to begin to steadily increase it, with many analysts expecting it to reach 1% by the end of 2022.

Worryingly, GDP growth slowed to only 1.3% in the three months to September, leaving it more than 2.1% below its pre-pandemic level in Q4 2019.

When inflation is running high and the economy is growing strongly, the received wisdom is to raise the base interest rate. If inflation is low, and growth is also slow, then it’s best to lower interest rates. However, the UK (along with the EU and USA) is in a sticky situation where inflation is rising substantially above official targets, while growth is unbendingly slow.

And this put the Bank of England in a bind. It can either choose to raise interest rates, which could hit asset classes like the FTSE 100 and kill off the green shoots of the UK’s post-pandemic recovery. Or it allows the cost-of-living crisis to escalate even further.

Will the base rate rise in December?

Due to rising oil prices, petrol is at its highest price since 2012. The cost of energy is soaring, with multiple suppliers going bust due to the price cap. Meanwhile, the UK is missing 100,000 lorry drivers, leaving shop shelves increasingly bare. Moreover, cheaper goods are more likely to be missing on the shelves as transport space is at a premium. And this hits the poorest consumers the hardest. In addition, the supply chain crisis is wreaking havoc on the price of everyday goods, with the lack of microchips for new cars sending the second-hand car market into overdrive.

Moreover, there are currently 1,172,000 job vacancies in the UK, with an unemployment rate of only 4.3%. In this employee market, employers are being forced to raise wages to attract and retain staff. However, they also must increase prices to pay for these wage increases. And in turn, employees demand even higher wages. This ‘wage-price’ spiral can create a damaging and self-sustaining wave of inflation.

But taxes are rising soon. National Insurance is going up by 1.25 percentage points next April. Council tax will rise by 5% in most areas. Income tax bands are being frozen until 2026. Corporation tax is increasing to 25% from 19% in 2023. There’s even talk of the student loan repayment threshold for Plan 2 graduates being lowered from £27,295 to as low as £22,000. In theory, this organic limit on income will hit at the same time as inflation is set to peak. This could reduce the need to raise rates significantly higher.

What could this all mean for the FTSE 100?

First off, it’s worth bearing in mind the age-old adage: time in the market beats timing the market. After the early 00’s dot-com bubble pop, 2008 credit crunch and 2020 pandemic mini-crash, the FTSE 100 has always recovered. Even if in the past, it’s taken years.

And rate rises aren’t guaranteed. Forex traders expected the Bank of England to increase the base rate to 0.25% this month. And it declined to do so, arguing that raising rates domestically could do too much damage to the jobs recovery while having little impact on the global supply chain squeeze. But on Monday, Governor Andrew Bailey said he was ‘very uneasy’ about the rising cost of living.

And on the assumption that rates do rise soon, the impact on the FTSE 100 is likely to be negative. Many companies on the index carry sizeable debt, which would cost more to service. Any new credit would become harder to acquire, and more expensive to pay back, constraining growth. And the last time rates rose, from 0.5% to 0.75% in August 2018, it lost 1,000 points in less than four months.

At 7,256 points right now, the FTSE 100 has gained 15% in the past year. It only needs to rise an additional 7% to reach its all-time high of 7,749 it struck on 31 July 2018. With the European Central Bank warning of ‘exuberance’ in global asset classes, some investors might consider an interest rate hike as the catalyst for a FTSE 100 dip.

But if rates do rise, some stocks will benefit more than others. Banks like Lloyds, the UK’s largest mortgage lender, will see profits rise on credit repayments. Mining stocks like Barrick Gold or Glencore should also see rises, as investors seek the relative safety of raw minerals. And energy companies like BP or Shell have also performed well historically.

A rate rise offers opportunities to forex traders as well. There’s plenty of opportunities for the savvy investor at IG. What do you think will happen next?

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*Based on revenue excluding FX (published financial statements, June 2020).