The Analyst: where to invest when interest rates are falling

Last week, the Federal Reserve cut interest rates by 0.25% to a range of 4-4.25%,while the Bank of England kept them on hold at 4%.

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The Fed move is seen by some analysts as unusual given that inflation is still above its 2% target (rising to 2.9% year-on-year in August 2025) and unemployment is relatively low, while equities are at record highs. Fed chair Jerome Powell framed the decision as “risk management”, given evidence of some deterioration in the labour market. The dot plot highlighted sharp divisions, with one policymaker projecting 125 basis points (bps) of cuts by year end, while others anticipated only two additional quarter-points cuts.

In the UK, the Bank of England left rates unchanged but slowed the pace of quantitative tightening to £70 billion per year from £100 billion, requiring £29 billion in active bond sales, with 20% in long-dated maturities. UK 30-year gilt yields climbed toward 5.70%, their highest since the 1990s, driven by persistent inflation and debt concerns. UK CPI remained high at 3.8%.

When economies slow or inflation rises, central banks have several tools at their disposal, one of the most popular being interest rate cuts. Such changes spread through financial markets, influencing both stock performance and investment returns. Therefore, for investors, it’s important to be aware of both the current interest rate and market expectations for future direction. Borrowing costs and investment returns are closely connected. Understanding this relationship can help investors navigate change, uncover opportunities for income, and maximise returns in a lower rate environment.

Cash and money markets

Beyond maintaining an emergency or rainy-day fund, it makes sense for investors to allocate cash savings, but only when they can earn a positive real return (a return that exceeds inflation). Otherwise, negative real returns erode the value of cash over time, effectively resulting in a loss of purchasing power.

With interest rates expected to trend downward, investors would experience the impact most directly in very short-term fixed income instruments such as money market funds and short-dated gilts, both of which are likely to see declining yields. Reinvestment risk occurs as rates fall and these short-dated instruments mature, meaning the prevailing yields in the market for purchasing new bonds is lower.

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Still, money market funds remain a highly liquid place to allocate cash and are expected to deliver returns similar to, or potentially higher than, traditional deposits, while carrying a similar level of risk.

One example is the Royal London Short Term Money Market fund, which invests in short-dated cash instruments, including certificates of deposit, time deposits, and call deposits from a range of high-quality banks. It may also hold UK Treasury Bills or short-dated gilts. The fund’s objective is capital preservation, with a target of outperforming SONIA (the Bank of England’s Sterling Overnight Index Average), net of fees. At present, the fund offers a yield of over 4%, with an ongoing charge of just 0.10%.

Bonds

Bonds are widely regarded as the main beneficiaries of falling interest rates. As rates decline, existing bonds with higher coupons become more attractive compared with newly issued ones, pushing up their prices. This price appreciation is most pronounced in longer-duration bonds, which are more sensitive to interest-rate changes.

For investors holding bonds purchased when rates were high, this dynamic creates a “double benefit”: steady income from higher coupons and the potential for capital gains as prices rise. Conversely, for new investors, falling rates reduces the future income available from newly issued bonds, making timing important.

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With central banks now pivoting towards rate cuts after years of tightening, longer-dated, high-quality government and corporate bonds look attractive. Yields have risen significantly in recent years, creating an opportunity to lock in relatively high income streams before rates move lower.

For broad exposure, Vanguard UK Government Bond Index fund tracks the performance of the Bloomberg Barclays UK Government Float Adjusted Bond Index (hedged to sterling), which can be effective. This index captures the universe of GBP-denominated Treasury and government-related securities with maturities greater than one year. At present, the fund offers a yield to maturity of around 4.5% with a modest ongoing charge of 0.12%.

Equities

Investors often assume lower interest rates automatically boost equities through reduced borrowing costs that support corporate earnings and valuations. While this is often true, the reality is more nuanced. Markets tend to price in rate cuts early, and equity returns depend not only on rates but also on growth prospects, inflation dynamics and geopolitics. In fact, equities can perform well even when rates are rising.

That said, some sectors benefit more than others when rates fall. Growth-oriented sectors such as technology, consumer discretionary, and real estate often see stronger gains, while small-cap stocks may also benefit as they typically carry higher debt levels and benefit more from reduced financing costs. Conversely, banks may struggle as falling rates compress net interest margins, while energy companies may lag if lower rates coincide with slowing global demand.

Another important consequence of lower rates is the relative attractiveness of equities versus bonds. As bond yields decline, investors often shift towards equities in search of income and growth. Dividend-focused strategies become especially appealing in this environment, as they can replace some of the lesser income from bonds while offering resilience in volatile markets.

Companies with long track records of paying and growing dividends have historically shown lower volatility than non-dividend payers. Dividends are also one of the most reliable components of long-term equity returns, helping cushion portfolios during downturns.

The current dividend yield on UK equities, as represented by the FTSE All-Share Index, stands at 3.35%. This compares less favourably with the Bank of England’s base rate of 4%, the 10-year gilt yield of 4.7%, and the prevailing consumer price index (CPI) inflation rate of 3.8%. However, UK equities remain well supported by attractive valuations and have scope for capital appreciation on top of any returns from dividend income.

Diverse Income Trust Ord (LSE:DIVI): this UK-focused trust invests across companies of all sizes, with a bias towards medium-sized and smaller businesses. Unlike many UK equity income funds, which concentrate on large-cap stocks, the trust’s differentiated approach includes more than 130 holdings. The trust currently offers a 4.5% yield and trades at a discount of 10%.

Gold and other commodities

Commodities, particularly precious metals such as gold and silver, tend to rise in value when interest rates fall. This is largely due to their inverse relationship with real interest rates (nominal rates adjusted for inflation). Lower rates mean lower real yields, making gold and silver more appealing as a store of value. As a result, such commodities can serve as an effective diversifier in a multi-asset portfolio in periods of monetary easing.

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One option is the WisdomTree Enhanced Commodity ETF - USD Acc GBP (LSE:WCOB), which invests across industrial metals, precious metals, energy, and agriculture. The exchange-traded fund (ETF) combines passive tracking of the Optimised Roll Commodity Index with active enhancements designed to outperform the widely followed Bloomberg Commodity Index. With disciplined cost management and a diversified structure, the fund is well positioned to benefit from falling rates. The ETF’s ongoing charge is 0.35%.

Portfolio perspective

Global markets have been volatile for much of the year, driven by tariff escalations and a slowing US economy. Recently, some stability has returned as trade negotiations progress and the Fed eases monetary policy.

While bonds may offer short-term capital gains, their declining yields are pushing investors towards equities and alternatives such as commodities and gold, which often benefit when real yields are low.

In this environment, investors must balance risk and reward carefully, adjusting portfolios to capture opportunities while mitigating downside risks. Active strategies can be especially valuable, offering the flexibility to adapt to changing conditions, seize emerging opportunities, and reposition portfolios with agility.

Regardless of where interest rates move, maintaining perspective, staying focused on long-term objectives, and ensuring proper diversification remain essential to building and maintaining resilient portfolios.