10 Jun 2024
In the Clash of the major central banks, who will cut interest rates first and when? We share our views.
Soundcheck complete, support band finished, the stage is set.
East of the Atlantic, headline inflation is falling from its peak. Wage growth is proving less intense than feared. Rates are around 2% above the neutral rate. The European Central Bank (ECB) and Bank of England (BoE) are ready to cut. Showtime will (likely) be June 2024.
However, the lead guitar is out of tune – the US. With resilient labour markets, stronger-than-expected consumer activity and stubborn inflation, the case for aggressive rate cuts is waning. We still think the US Federal Reserve (Fed) will cut this year, but if the first quarter proves to be the norm and not a blip, the extent of those cuts will be limited.
This sets up markets for the rest of 2024: the Clash of the central banks.
If the Fed stays, can the ECB and BoE go?
Or, more specifically: if the Fed’s cutting cycle is limited, does that limit European rate cuts?
If I go there will be trouble
Europe and the UK are two discrete economies, and their central banks are entirely independent of the Fed. Does it matter that they’re plotting different courses from the US?
Question 1 for European central banks: is the story of US economic resilience happening in a vacuum? Or will Europe (and the UK) catch up? We believe the US is out on its own. The structure of the US mortgage industry means it takes a long time before a hike in interest rates affects the man on the street – longer than in Europe. Added to the mix, President Biden’s Inflation Reduction Act is really a fiscal splurge. The US is running a fiscal deficit of over 6%.
Question 2: can they both go before the Fed? Yes, of course. They have done it before, and they can do it again.
The ECB is cutting in June regardless of what happens in the US. The BoE seems somewhat confused, but with inflation heading lower and the labour market loosening, the conditions are there for an early summer cut.
Question 3: European central banks will go first, but how far can they go without the Fed? That’s the big question for markets.
Divergent cross-Atlantic interest-rate policy affects exchange rate differentials. All else being equal, if one central bank cuts more aggressively than another, the value of the cutting central bank’s currency falls. Both Europe and the UK are import-led economies, so a weakening euro or sterling would lead to imported inflation.
For Europe, geographic scale, economic diversity and healthy corporate profit margins mean imported inflation should be less of an issue. The UK may prove more inflation-prone, given structural challenges regarding labour provision and productivity.
If I stay it will be double
What happens if the European central banks limit their interest-rate-cutting cycles?
The trouble comes from staying too tight for too long. The UK and Eurozone economies have room for some optimism. Keeping rates too high, however, will dampen growth. Elevated inflation is no good to anybody, but neither is stunted growth from overly tight monetary policy.
Both central banks have an inflation-targeting mandate. They were too slow to raise rates during 2021-23 for fear of over-tightening. They should not make the same mistake on the way down. If the internal conditions warrant cuts, they should cut.
On balance, we believe the risk of the BoE and ECB delaying like the Fed outweighs that of going it alone.
Well, come on and let me know
What are markets pricing? Indecision!
Investors don’t believe European central banks can materially go it alone.
By the end of 2025, markets see the ECB delivering five cuts and the BoE, like the Fed, delivering four cuts. This is a massive reduction in the projected cuts relative to the start of the year. As we stated in our article in January ‘FOMO and the FOMC’, the year-end rally went too far. We now believe pricing in the EU and particularly the UK has gone too far the other way.
The EU can deliver more rate cuts than the Fed. The UK should not have the same number of projected cuts as the US.
Why do markets believe the UK will mimic the US cutting cycle?
Primarily because the latest round of UK jobs and inflation data did not play ball. Although headline inflation is coming down, services inflation and wage growth are still stubbornly high.
The UK labour market is weakening at pace. We expect wages will fall, and services inflation will fall with them.
Finally, our friends at the BoE aren’t covering themselves in glory when it comes to communication. As market participants, we don’t expect a running commentary, but confusion affects credibility. The BoE seems confused.
This indecision’s bugging me
Where do markets go from here?
The next couple of months should bring much-needed clarity.
In the US, we’ll find out whether the first quarter’s economic strength was a blip in the data. We’ll then have a better idea of how much and when the Fed cuts rates.
In the EU, we’re confident the ECB will reduce rates in June…
Finally, in the UK, the data should give markets and the BoE more confidence that the inflation battle is close to its conclusion.
So you gotta let me know – should I stay or should I go?
We see no reason why the European central banks can’t get ahead of the Fed. We still expect the US to cut rates this year, but the inflation dynamics in the US are different from what is being experienced this side of the Atlantic. As such, European central banks should have no issue following the immortal words of Joe Strummer: they should go!
Risk warning
The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.