Who Will Cut Interest Rates First: The Fed Or The ECB?

Central Bank

Summary:

Expectations for reductions have significantly cooled, but capital markets project the European Central Bank to act first and more aggressively throughout the year.

A shift in the economic cycle is expected in 2024 that will lead central banks to embark on a program of interest rate cuts. The high expectations of capital markets were dampened by stubbornly persistent U.S. inflation data in January, and the Federal Reserve is not expected to make its first interest rate cut until June. But the European Central Bank (ECB) may beat the Fed to the punch with a rate cut in April, as it faces tighter constraints than the Fed. ECB President Christine Lagarde’s room for maneuvering is limited by time and the Eurozone’s economic fragility.

The slowing inflation towards the end of 2023 raised expectations that central banks might halt interest rate hikes and set the stage for a series of cuts. The new year began with the Fed leading investors to speculate about rate cuts as early as March, which would signal the ECB to follow. Inflation had decreased more in the eurozone, and high interest rates threatened to push European economies into a recession.

Amid investor excitement over a swift decline in interest rates this year, central banks worked to temper expectations, emphasizing the need to remain vigilant against inflation. But after last week’s U.S. inflation data for January revealed a greater-than-anticipated rise in prices, particularly in core inflation, investors resigned themselves to no Fed or ECB rate cuts in March. But the ECB doesn’t seem to want to wait on the sidelines for the Fed to act, and might proactively consider an initial rate cut as early as April.

“There is little evidence that the ECB will wait for the Fed,” said David Alexander Meier, an economist with Julius Baer. “Current economic data indicates increasing divergence, with U.S. data indicating delayed Fed rate cuts and eurozone data pressuring the ECB for earlier rate reductions.” In the U.S., prices grew in January by 3.1% annually and core inflation by 3.9%, while in the eurozone, inflation for the first month of the year stands at 2.8%. Regarding economic growth, the U.S. GDP increased by 3.3% in the fourth quarter of 2023 on an annualized basis, compared to the eurozone’s 0.1% annual growth, barely avoiding a technical recession.

The U.S. economy may not require an immediate rate cut, which is reflected in the futures market. Market expectations have shifted from anticipating six or seven rate cuts by the Fed in 2024, to now projecting only three or four. The total expected interest rate decrease for this year and next has dropped from 235 basis points a month ago to the current estimate of 165 basis points.

European futures now project an 83% chance of an ECB rate cut in June and 40.7% in April, down from 110% and 52% a month earlier. The Fed will likely be more conservative, so markets project a 65% chance of a cut in June and 31% in May. A month ago, there was an 80% likelihood of Powell cutting rates in May and 95% in June.

According to Alex Rohner of J. Safra Sarasin, “Eurozone data has slightly improved but still falls short of the recent strength shown by the U.S. economy. Inflation is declining faster in the eurozone than in the U.S., possibly enabling the eurozone to cut interest rates before the Fed.” ECB rate cuts could also be more aggressive than the Fed’s in 2024, noted Orla Garvey of Federated Hermes. “The ECB is expected to make more cuts this year than the Federal Reserve, with the Fed catching up in 2025.” Gilles Moëc, Chief Economist at Axa IM, shares this view. “The Fed has valid reasons for being cautious in its rate-cutting timeline. Market expectations indicate the ECB will cut rates more than the Fed by the end of 2024, reflecting the increasing divergence between the real [non-financial] economies of U.S. and the eurozone.”

The Fed has often acted before the ECB in the past. During the dot-com crash in 2000, it reduced rates five months before the ECB. In 2007, just before the 2008 financial crisis, the Fed cut rates over a year earlier than its European counterpart. The Fed also acted ahead of the ECB in March 2022, starting rate hikes to tackle post-pandemic inflation. This time, factors like lower inflation and Germany’s economic slowdown support those who believe the ECB may cut rates sooner and more aggressively than the Fed. Bank of America warned that if the ECB “postpones rate reductions, it could lead to expensive ramifications that may be hard to rectify through swifter reductions at a later time.”

Source：ELPAIS

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Samantha Luan

Economic

Central Bank

This has been in the works for a while and has come out in bits and pieces, but today the Fed made it official in the FOMC meeting minutes: It doesn’t know how far it can take QT without blowing up stuff, but it wants to reduce its balance sheet as far as possible without blowing up stuff. QT has already reduced the Fed’s balance sheet by $1.34 trillion. And so far, nothing has blown up. But last time it did QT, the repo market blew up.

The issue with withdrawing liquidity from the market via Quantitative Tightening is that this liquidity is taken out through a couple of drains that are close together – the Fed’s roll-off of Treasury securities and MBS – but liquidity has to flow there from all directions, and it may drain out faster in one corner, and that corner then runs out of liquidity and blows up, while there is still excess liquidity in other corners.

Yields solve that problem normally. The corner that is running out of liquidity will be willing to pay higher yields to attract liquidity from the corner that has excess, but the process is not instant; it can take too much time, and then something runs out of liquidity and blows up while at the other side of the markets, there is too much liquidity.

This hasn’t happened yet in QT-2, which is still running “smoothly,” as the FOMC minutes said today.

But it happened with QT-1 in September 2019, when the repo market blew out because banks were running low on excess liquidity and refused to lend to the repo market, and a repo-market panic ensued and threatened with contagion, and so the Fed stepped into the repo market and helter-skelter doused it with nearly $400 billion in liquidity, which raised its balance sheet again, thereby undoing a big part of QT-1. And that is to be avoided this time.

So the Fed’s solution seems to be two-fold, that’s what we see:

1. Withdrawing the liquidity slowly enough so it has time to flow to where it’s needed with minimal disruption, allowing QT to drain liquidity evenly until the balance sheet reaches the lowest comfortable level without blowing anything up. If something blows up, it would put a premature end to QT.

This topic was first broached in early January by Dallas Fed president Lorie Logan and dealt with at the time here in our illustrious comments. Slowing QT would reduce “the likelihood that we’d have to stop prematurely,” she’s said. And today, it was officially put on the table via the FOMC minutes.

2. A Standing Repo Facility that everyone knows will be there; and its mere presence, even if inactive, will tamp down on a panic. The Fed had an SRF through 2008, that was its classic measure to deal with market issues before QE, including during 9/11 when markets froze and were shut down.

Repos mature within a day or within a week or two weeks, or some relatively short term, and if they’re not rolled over, they then vanish from the balance sheet automatically. They don’t cling to the balance sheet for years or decades like QE assets.

But in 2009, the Fed skuttled its SRF because it wasn’t needed with the huge amount of QE the Fed was doing at the time. But it didn’t revive it when QT started, and in September 2019, after nearly two years of QT, with no SRF on standby, it had to scramble and improvise as the repo market was already blowing up.

So this time around, in July 2021, a year before QT started, the Fed revived its classic SRF in preparation for QT. So that’s done.

The minutes make the beginnings of a plan official.

Logan is just one FOMC member and didn’t officially speak for the group in her long detailed speech. “As always, the views I express are mine and not necessarily those of my colleagues on the Federal Open Market Committee (FOMC),” she said at the beginning. Today, the minutes showed that the Fed’s institutional thinking is with Logan on this.

The minutes made five important points about the future of QT:

1.So far, so good, everything is cool with QT. No hurry to change anything.

2.QT is an important part of getting inflation down.

3.The Fed doesn’t know how low the balance sheet can go without blowing up stuff.

4.Slowing QT would allow the Fed to reduce its balance sheet further than if it kept going at the current speed, as it would lower the risk of something blowing up, which would force the Fed to end QT prematurely (see QT-1).

5.Even after the Fed starts cutting rates, QT can continue “for some time.”

In the words of the minutes:

“Participants observed that the continuing process of reducing the size of the Federal Reserve’s balance sheet was an important part of the Committee’s overall approach to achieving its macroeconomic objectives and that balance sheet runoff had so far proceeded smoothly,” the minutes said,

“In light of ongoing reductions in usage of the ON RRP facility, many participants suggested that it would be appropriate to begin in-depth discussions of balance sheet issues at the Committee’s next meeting [mid-March] to guide an eventual decision to slow the pace of runoff,” the minutes said.

“Some participants remarked that, given the uncertainty surrounding estimates of the ample level of reserves, slowing the pace of runoff could help smooth the transition to that level of reserves or could allow the Committee to continue balance sheet runoff for longer,” the minutes said.

“In addition, a few participants noted that the process of balance sheet runoff could continue for some time even after the Committee begins to reduce the target range for the federal funds rate,” the minutes said.

What this tells us…

There will be more color on this topic at the next FOMC meeting (March 19-20), and we’re looking forward to the inane, manipulative questions the reporters will hammer Powell with at the press conference.

What this tells us is that the Fed did learn a lesson from the repo market blowout that ended up reversing part of QT-1. And it proceeded methodically to implement those lessons by re-establishing the classic SRF before QT-2 even started, and then by trying to avoid the kind of blowout it was hit in the face with in 2019, so that it won’t have to end QT prematurely.

Source：wolfstreet

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Damon

Economic

Canadian Economy Softening

Over the past few months, economic data in Canada has been mixed, but overall showing signs of softness. Canada's GDP contracted in the third quarter of last year and saw a slight rebound in the fourth quarter. GDP grew by 0.2% month-on-month in November, with Statistics Canada predicting a further 0.3% growth in December. If achieved, the fourth-quarter GDP annualized growth would be 1.2%, essentially reversing the downward trend seen in the third quarter.

Bank of Canada's Policy Shift Not Yet Complete_1

However, the rebound in GDP growth in the fourth quarter may just be a "blip" in an economic downturn. Currently, the labor market seems to be gradually weakening. The latest employment report for January showed an increase of 37,300 jobs, but this growth was mainly driven by part-time and public sector employment. In January, full-time employment actually decreased by 11,600, marking the second consecutive month of decline, while private sector employees increased modestly by 7,400. The unemployment rate slightly declined to 5.7%, but it remains higher than the mid-2022 low of 4.9%. Overall, the January report aligns with the trend of a gradually weakening labor market.

Bank of Canada's Policy Shift Not Yet Complete_2

The fundamentals of household finances also align with moderate growth in consumer spending. With inflation easing, the growth of real disposable income has returned to positive territory. However, despite a 1.5% year-on-year growth in real income in the third quarter of 2023, the growth in real income is only comparable to consumer spending growth over the past four quarters. Additionally, the sharp increase in household debt costs poses a potential downside risk to consumer spending. By the third quarter of 2023, the proportion of interest costs to disposable income had risen to 9.3%, while total debt costs had risen to 15.2%, both reaching new highs in years. In summary, there is no data to support the claim of "strong consumer spending growth in the coming quarters."

Bank of Canada's Policy Shift Not Yet Complete_3

Meanwhile, the outlook for businesses continues to cool down. In the Bank of Canada's (BOC) fourth-quarter Business Outlook Survey, the overall business sentiment index improved slightly but remained at low levels. The future sales indicator further weakened to -10, the lowest level since 2009, excluding the pandemic period. In other aspects, overall profit growth for businesses is slowing, and industrial capacity utilization has fallen below 80%, all of which could inhibit future investment spending. Considering the consumer and business backdrop, even against the backdrop of a soft landing in the US economy, Canada's GDP is expected to further slow to 0.9% in 2024.

Bank of Canada's Policy Shift Not Yet Complete_4

Monetary Policy Shifting

As the Canadian economy slows, the monetary policy of the BoC is shifting from assessing whether rates are restrictive enough to how long they need to stay at current levels. The BoC perceives that with the economy's growth subdued, supply has caught up with demand, and the economy appears to be operating under mild supply excess. While labor market conditions have eased somewhat, wage growth remains elevated.

The BoC's assessment of inflation is less optimistic, with housing costs remaining the biggest factor driving inflation above target. Despite normalization in corporate pricing behavior, core inflation indicators have not shown sustained declines. The BoC stated that concerns persist about the inflation outlook, particularly the sustainability of potential inflation, and the BoC would like to see further slowing in core inflation.

There has been a significant shift in policy guidance, with the BoC dropping its tightening bias at its January meeting, removing the wording "further rate hikes may be required." BoC Governor Tiff Macklem indicated a shift in focus from discussing the restrictiveness of policy rates to how long they need to be maintained at current levels. In other words, the BoC's focus has shifted from how "high" policy rates need to go to how "long" they need to stay at elevated levels.

Bank of Canada's Policy Shift Not Yet Complete_5

As the BoC's monetary policy shifts, the latest inflation data is also encouraging. January CPI slowed to 2.9% year-on-year, and average core CPI also slowed to 3.4%, both exceeding expectations, suggesting increased likelihood of rate cuts in the coming months. However, housing costs and service sector inflation exhibit some stubbornness and resilience. Additionally, the three-month annualized growth rate of average core CPI (a key indicator closely monitored by the BoC) remains at 3.2%, well above the 2% inflation target. The BoC's rate cuts will depend mainly on sustained soft economic growth and the labor market beginning to more significantly impact wages and prices. If core inflation trends remain in the range of 2.5-3% and wage growth slows to around 4%, the BoC's willingness to cut rates will become stronger.

Given these factors, it is premature for the BoC to cut rates, and it is expected to keep rates unchanged in March and April, with no rate cuts before June. Additionally, Canada's economic growth is expected to slow but not to the point of recession.

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Ukadike Micheal

Economic

Stocks

European stocks surged to a record high, echoing the momentum of their Wall Street counterparts, driven by optimism about economic growth and potential monetary policy easing. The Stoxx Europe 600 Index marked a 0.9% gain, reaching 495.71 points, surpassing its previous peak in January 2022. The rally was fueled by robust performances from tech stocks, notably Nvidia Corp., which delivered an impressive sales forecast.

In a pattern reminiscent of the US market, concentration of returns has been a prevailing theme in Europe, with four key stocks - ASML Holding NV, Novo Nordisk A/S, SAP SE, and LVMH - contributing to 65% of gains in the benchmark since the year's onset. These companies, spanning chip equipment manufacturing, pharmaceuticals, software, and luxury goods, have all experienced double-digit growth in 2024.

Amid the sector-specific successes, indications of a resilient global economy are bolstering investor confidence. Anticipation of global central banks initiating interest rate cuts later in the year is further propelling equity markets, mirroring the trajectory that led the US benchmark S&P 500 Index to achieve a record high. Despite potential disappointments in eurozone growth, European stocks appear unfazed.

While concerns about high valuations have arisen, particularly among top-performing stocks, market observers argue that these valuations are justified by superior earnings growth, strong balance sheets, and sustainable competitive advantages. Luxury stocks, exemplified by LVMH's robust sales, are regaining investor favor, contributing to broader market gains.

However, challenges persist, with China's selective stimulus measures leading to underperformance in the basic resource sector. Retail, particularly weighed down by Hennes & Mauritz AB, has also lagged. Some strategists caution that the prevailing bullish sentiment may be approaching excessive levels, emphasizing the need for vigilance in the face of potential market corrections.

On the flip side, proponents of European equities argue that the recent rally has predominantly favored US and technology-related stocks, leaving room for a broader market upswing. Emmanuel Cau, a strategist at Barclays Plc, suggests there is potential for the rally to expand, highlighting the under-owned status of European equities in the current market landscape.

As European stocks ride the wave of optimism and record highs, the nuanced dynamics within individual sectors and the broader market underscore the complexities and opportunities in the evolving landscape. Investors are closely monitoring how these factors play out in the coming months, navigating potential challenges while seeking new avenues for growth in the European equity market.

Source: Financial Times

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Samantha Luan

Economic

Adding to signs that Britain's shallow recession of last year is likely to be short-lived, the preliminary February S&P Global/CIPS UK Composite Purchasing Managers' Index (PMI), which spans services and manufacturing firms, rose to 53.3, the highest in nine months, from January's 52.9.

Economists polled by Reuters had forecast no change from January's reading.

But there were potential areas for concern for the BoE in the survey including strong growth in wages among services firms and Red Sea tensions hitting factory supplies, pushing a measure of price increases by businesses to its highest since July.

Chris Williamson, S&P Global Market Intelligence's Chief Business Economist, said the survey pointed to the economy growing by 0.2% or 0.3% in the first three months of 2024 after contracting in the third and fourth quarters of last year.

That is likely to be a relief for Prime Minister Rishi Sunak who has had to endure taunts of "Rishi's recession" from the opposition Labour Party which is riding high in opinion polls ahead of a national election expected later this year. Williamson said the pick-up was being led by demand for financial services amid expectations of imminent rate cuts while manufacturing activity continued to contract and consumer-facing services firms were still battling cost-of-living pressures.

"With growth accelerating and prices on the rise again, February's data mean policymakers are increasingly likely to err on the side of caution when considering the appropriateness of cutting interest rates," he said.

Williamson said there was a risk inflation gets stuck at its most recent level of 4% rather than fall to the BoE's 2% target soon, as widely expected.

The central bank this month signalled that the time might be approaching for cuts to its benchmark lending rate which is at its highest since 2008. But most policymakers are still looking for evidence that inflation pressures will not persist.

Thursday's survey showed average cost burdens increased in February at the fastest pace for six months, pushed up by higher labour costs as well as rising freight costs for manufacturers which were linked to the Red Sea crisis.

Among services firms, the PMI's headline measure held at 54.3. Manufacturing remained below the no-growth threshold of 50.0 but edged up to 47.1 from 47.0 in January.

Overall, new business increased at the fastest pace since May last year but companies were cautious about hiring due to the strong increases in pay.

Source：Reuters

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ING

Commodity

Energy: Brent time spreads strengthen

The oil market managed to move higher in the morning trading session amid indications of a tightening crude market. ICE Brent traded above US$83/bbl while the prompt spread also managed to see its backwardation widen to US$0.95/bbl, hovering near three-month highs. However, the API numbers remained largely bearish for the oil market, reporting a large build over the last week.

US oil inventory numbers overnight from the API show that crude inventories increased significantly by 7.2MMbbls last week, compared to the average market expectations for a build of around 4MMbbls/d. Similarly, Cushing crude oil stocks are reported to have increased by 0.7MMbbls. However, product inventories remained mixed, with gasoline stocks growing by 0.42MMbbls, while distillate stocks fell by 2.9MMbbls over the week ending 16 February. The more widely followed EIA inventory report will be released later today.

Metals: Zinc ends 2023 in surplus

The recent data from the International Lead and Zinc Study Group (ILZSG) show that the global zinc market ended 2023 with a supply surplus of 205kt compared to a deficit of 73kt a year earlier. Total refined production rose by 3.8% year-on-year to 13.9mt (driven by higher Chinese output), while total consumption increased 1.7% year-on-year to 13.7mt in 2023. As for lead, total production reported gains of 2.8% YoY to 12.85mt, while consumption rose by 1% YoY to 12.76mt last year. The lead market was estimated to have seen a supply surplus of 92kt in 2023, compared to a supply deficit of 134kt during the same time in the previous year.

Meanwhile, Vale said that the operating license for its Sossego mine (its second largest copper mine) located in Para, Brazil has been suspended by the State of Para's environmental secretary. The company didn’t mention the reason for the suspension and said that it complies with conditions and socio-environmental controls of its activity. Vale produced around 66.8kt of copper in the Sossego mine last year.

Agriculture: Ghana lowers cocoa production estimates

Recent estimates from the Ghana Cocoa Board show that cocoa production in the country is likely to fall to around 650kt-700kt in 2023/24, lower than the previous estimates of 850kt. This would be the lowest annual output in 14 years. The revision in the estimates is mainly due to unfavourable weather conditions and smuggling. Cocoa prices jumped over 4% yesterday to settle at the highest level on record amid expectations for global supply shortages.

In its latest report, the Rosario Board of Trade revised down the Argentina’s soybean production estimates to 49.5mt for the 2023/24 season, lower than the 52mt estimated in January. The downward revision in the estimates was majorly due to continuous heat waves in the Pampas crop belt. Similarly, corn production estimates were also revised lower by 3.4% MoM to 57mt for the period.

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Samantha Luan

Economic

France February Flash Services PMI 48.0 Vs 45.6 Expected_1

Those are strong beats across the board and the euro is up to fresh highs on the day now. This diminishes the odds of an April rate cut, now seen at ~43%. Going back to the readings, the services print is a 8-month high while the manufacturing print is a 11-month high. Both are seen rebounding amid tentative signs of improvement in demand conditions while new orders also fell at its softest rate since last May.

HCOB notes that:

“France's economy is in recovery mode. Even if the economy continues to shrink, this is happening at a much slower pace, as the composite PMI has improved by more than three points. This is mainly due to demand, which is no longer declining at a rapid pace. The pace of output price growth has also slowed considerably. Our HCOB Nowcast, which incorporates the latest PMI figures, has improved as a result.“

“The French service sector is edging closer to growth. Exporters are partly responsible for this glimmer of hope, and one possible explanation for this would be an improvement in demand for tourism. It is crucial for the French economy that the service sector returns to growth as quickly as possible in order for the second-largest euro area economy to recover. After all, the sector accounts for almost 80 % of total output.”

“France's manufacturing industry is gradually making a comeback. The new orders index has risen by more than seven points, which has significantly curbed the slump in production. Whether this is just a one-off or the start of a trend is still to be seen, especially as manufacturers’ expectations for future business activity remain pessimistic and well below their long-term average.“

“These HCOB PMIs for prices will certainly please the ECB. Services inflation is currently acting as the main driver of consumer price inflation in France and our survey shows a further significant slowdown in February. Output price inflation in the services sector has reached its lowest in almost three years. It is possible that the index will soon fall below the expansion threshold of 50, as has been the case in the manufacturing sector since the middle of last year.”