ECB’s Lagard makes rate cut history

Posted 7 June 2024

Rate cuts at last. In a heavily anticipated decision, the European Central Bank (ECB) cut interest rates for the first time in five years on Thursday. Perhaps more poignantly, it was the very first time in its 25 years existence that the ECB cut before the US Fed. European stocks rallied in the build up, and got another boost following the decision and accompanying commentary. They were not the only ones: US equities had another strong week, with focus again on the dominant mega tech sector. Underlying the global equity rally was a sharp move down in bond yields – which make stocks more attractive by comparison, while stimulating business investment and demand. Markets are excited about easier monetary policy yet again.

Is three the new two?

The ECB was not the first major central bank to cut rates; the Bank of Canada (BoC) beat them to the punch on Wednesday, becoming the first G7 central bank to lower rates during this monetary cycle. Both the BoC and the ECB delivered 25 basis point cuts, and spoke of inflation coming closer to the 2% target, allowing less restrictive policy. ECB president Christine Lagarde said this likely marked the start of a “dialling back”, but the bank warned it was “not pre-committing to a particular rate path”.

Nobody expects this to be the start of a full-blown easing cycle from the ECB. In fact, implied market expectations for a second rate cut in September fell slightly in the aftermath – from 70% to 60%. But markets certainly expect the direction of travel to be down in the medium-term: the Bank of England is set to follow suit in the summer, however, after stronger-than-expected employment data from the US, expectations of an all-important US Federal Reserve (Fed) cut in the autumn have once again moved towards the end of year horizon.

This is happening while inflation remains consistently above the official 2% target, though. Indeed, the ECB does not think inflation will fall below that until late 2025 – but they are cutting rates regardless. It begs the question of whether central banks have implicitly moved to a 3% target instead. As we wrote recently, 2% is pretty arbitrary and, given dramatic shifts in the global economic structure – both recent and expected – there is a case to be made that a slightly higher target might better allow for stable growth.

This is truest in the US. Growth and inflation have been above expectation for so long – pushing the timeline for Fed cuts further and further back in the early part of this year. But expectations have now stabilised, and it emerged on Wednesday that the US added fewer jobs than expected in May. That reinforced markets’ expectations of rate cuts both this year and next. The Fed is not expected to hit its official 2% target anytime soon, but everyone expects it to push ahead with a new rate cycle anyway. Markets find that very comforting.

Goldilocks returns.

We wrote last week that equity gains were now more based on the strong profits being generated by US companies – in particular tech firms – than expectations of easier financial conditions. But this week’s action was all about what central banks have done or will do. Bond yields fell significantly and this delivered a sizeable boost for stock valuations and, therefore, prices. Does this challenge our assessment that fundamentals are driving markets?

Not exactly. Rate expectations were the key factor this week, but returns are still laser focused on companies that will produce the greatest profit growth. Investors’ darling Nvidia is perhaps the greatest example of this. The AI chipmaker is the world’s leading ‘growth’ company, and as such has massively benefitted from the move down in yields. But its outperformance – up an incredible 151% year-to-date, versus just 6.5% for the S&P 500 when excluding the so-called “magnificent seven” – is fuelled by its incredible profit growth. Q1 profits were up 600% from the year before, and it is expected to dominate the AI chip space in the years ahead.

This is the ‘goldilocks’ environment that markets long for. Growth is moderating enough for central banks to cut rates and start a new cycle, but is not weak enough to really hamper incredible profitability from business investment and resilient consumer demand. A key sign of this is that expected stock market volatility has fallen dramatically, and the cost of hedging positions against losses has dropped – suggesting that markets are in a mood to buy. The speed with which Saudi Aramco’s $12 billion share sale was gobbled up by markets this week is testament to that too. Say it quietly, but markets look positioned for another leg up.

On elections and markets.

Lastly, a note about elections. Less than a month away from a UK election that is widely expected to end 14 years of Conservative government, investors understandably want to know how it might affect their portfolios. As we have written before, the answer is very little – at least in the short-to-medium-term. Keir Starmer’s Labour Party has effectively committed to continuity in near-term fiscal policy, and any impactful tax rises will likely be far down the line.

Still, recent elections in Mexico, India and South Africa have shown that surprise results – even if the end result is something markets seem to broadly favour – can cause temporary stock market swings. The selloffs following the Brexit referendum and Donald Trump’s surprise victory in 2016 are also prominent examples.

Bloomberg’s John Authers covered this phenomenon in a column this week, and had soothing advice for investors. Betting on election results is risky, thanks to opinion polls usually having a wide margin of error, and markets generally being bad at predicting what politicians will do once in office. Mexico’s outgoing president Andrés Manuel López Obrador, for example, was seen as a dangerous leftist that could tank the economy, but ended his tenure as the only Mexican leader in modern history to leave the peso stronger than he found it.

Even if elections cause downward swings, in the short term, these tend to be overreactions which are quickly recovered – as after Brexit and Trump. Politics can make a difference to regional economic dynamics over the longer term, as the Brexit vote also showed, but such occurrences tend to be reserved for the very large turns in economic policy. We do not expect these UK elections to have a big impact on domestic, let alone global, markets. But even if it did, it would probably mean a short-term buying opportunity. It would take a lot to really upset markets at the moment.