Carmignac: Let the cuts begin!

June 3, 2024

The euro area is in better shape. The economy is expected to grow at +0.7% this year and double that next year, consumers are showing signs of rosiness and there is a rebound in demand. And yet, just shy of two years after initiating its tightening cycle, the European Central Bank (ECB) is expected to proceed with its first interest rate cut on 6 June. It will be the first of the major central banks to get the ball rolling.

On the policy-rate front, the objective is to reduce the ECB’s historic level of restrictiveness. Its governing council almost unanimously acknowledges the level of restrictiveness admitting that even with policy rates 50 basis points below where they stand today, it would remain so. Hence Thursday should see the first step in that direction, with a 25 basis point cut, bringing rates to 3.75% while inflation continues to trend down. This is a relief for the economy but still far from normalisation.

On the inflation front, wage data have been mixed. Negotiated wages are on the strong side, at +4.7% year on year, but forward-looking wage tracker indicators point at wage inflation decelerating towards 3%. This is of good omen for further disinflation in consumer prices down the line, with eurozone headline inflation touching 2% by the autumn. Core inflation is expected to follow suit and reach such a level by the middle of next year.

As such, market expectations of fewer than one interest rate cut per quarter for the rest of this year appears cautious. We wouldn’t be surprised to see the ECB proceeding with three or four cuts, and potentially more, in the case of an unforeseen slowdown.

Finally, with regards to the balance sheet, the Pandemic Emergency Purchase Program portfolio should be reduced by €7.5 billion per month from July. This means reduced purchases by the ECB over the second half of the year, while European treasury departments have so far issued less than half of the new debt for this calendar year. This issuance will have to digested by other market participants.

Such ’insurance’ cuts are positive for economic growth. They increase the probability of a soft landing for the euro area, or more precisely, of a better post-landing trajectory. The region is quite rate sensitive (the proportion of floating mortgages in southern Europe is high and the average maturity of corporate debt is relatively low) so the benefits of lower policy rates should be felt relatively swiftly.

This provides a favourable backdrop for corporate credit markets, particularly as money market funds will lose some of their attractiveness. Flows to credit markets are already strong, and additional support will likely further boost this.

It should also be favourable for European equities as whole and notably, those segments which have suffered from the restrictive monetary conditions given the prospects of a non-inflationary cyclical recovery. This is a sweet spot, especially as valuations in the region appear attractive both historically and compared to the rest of the world.

Regarding interest rates, markets seem to agree on the prospect of three cuts by the ECB in 2024 with the key rate landing at, or above, the 3% threshold within 12 months. Such a scenario appears optimistic as it does not factor in what the ECB could do if the economy slows. While we are constructive on the short end of the yield curve, we cannot rule out an underperformance of long rates on the back of better economic prospects and a smaller ECB balance sheet.

The divergence in monetary policies between the Federal Reserve (Fed) and the ECB is also of interest to investors. The ECB is set to cut rates in June, while the window of opportunity is closing for the Fed as the election draws closer. A hold until December is increasing likely. The prospects of a 2% differential in policy rates over the coming six months could be an issue for the ECB.

Should the Fed hold rates high for longer, and the interest rates differential shift too much in favour of the USD (with the EUR depreciating), this could mean imported inflation down the road for the common market. Such a sequence would mean that the ECB would be Fed dependent. But the EUR is currently holding well. Right now, it appears the ECB will proceed irrespective of what the Fed is doing, but if circumstances change and an outright reflating of the economy becomes a risk, policy divergence would clearly be an issue.