Carmignac: When the ECB & Fed diverge

13 september 2024

Kevin Thozet, a member of the investment committee at Carmignac reacts to today’s European Central Bank meeting and looks ahead to next week’s Federal Reserve meeting.

The European Central Bank (ECB) faces a conundrum

Weak economic growth, lower wage inflation data and contractionary leading indicators all hint at a further decrease in inflation across the euro area. Yet, services and domestic inflation – stubbornly stuck in the region of 4% - weigh against it, or at least entertain some form of doubt on the path ahead.

A 0.25% cut was the plan, but Lagarde is avoiding committing to a monetary policy path. And with the Frankfurt institution revising its 2024 inflation projections on the upside and growth expectation to the downside, we don’t expect clarity soon. Data dependency remains central.

The Federal Reserve (Fed) reaches a historic moment

In the US, economic growth and consumption remain resilient, but inflation is approaching the Fed’s target and the softening labour market means the door is open for gradual normalisation of policy rates, to reduce the restrictiveness of its monetary policy.

Having maintained its Federal Funds Rate in the 5.25%-5.50% target range for more than one year, we expect the Fed to initiate its cutting cycle next week with a 0.25% cut. With just two more meetings this year (November and December), an updated ‘dot plot’ (Fed members’ projections of policy rates) is likely to show it sticking its neck out over the short-term path for interest rates.

We expect the dot plot to signal two additional cuts by year end, along with Powell hinting he could go big if needs be. Indeed, any signal hinting the Fed is ‘behind the curve’ would likely see it moving with a jumbo cut of 0.5%.

Not all cuts are created equal

The ECB has already made a 0.25% rate cut this month, and the Fed is likely to follow suit next week. But their future actions might not be so synchronised.

The ECB has to deal with a precarious balancing act. Inflation has come down more than wages, and yet consumer confidence is showing little signs of improvements. Both economic growth and productivity  data are weak and prospects of fiscal austerity are mounting for 2025.

So, contrary to the Fed, which has paved the way for a full blown loosening cycle, the risk for the ECB is a possible “one and pause” or “one and one” cycle.

This divergence is clear in bond markets, with EUR rates underperforming their USD counterparts. Further, a different monetary policy path, also raises questions over the possible appreciation of the euro, which won’t help the competitiveness problems of region. This is also happening as growth is stalling – which is particularly bad timing.

The ECB must eventually resolve to do more than the six cuts priced over the next twelve months. But the risk is they do so later, rather than sooner, with the adverse impact of the time lag between policy and real economy effects, notably on the jobs market.

Investment implications

The policy rate cutting cycle has begun.

Fixed income markets are expecting policy rates in the euro area to go back to 2.0% within the coming year, while long-term core sovereign bond yields currently stand at 2.20%. In the US, policy rates are expected to land a touch below 3.0% while the 10-year hovers a mere 0.6% above at 3.6%.

Such a context pleads for some form of caution on long-term sovereign markets. Indeed, central banks are proactively cutting rates to avoid damaging the economy, while supply remains heavy. And, with quantitative tightening ongoing (further reducing the demand for bonds in the market), the risk is upward pressure on sovereign yields. Besides, some inflation premium seems warranted, as central banks lower policy rates even though inflation hasn’t come back to the 2% target yet.

In contrast, shorter-term sovereign bond markets appear more appealing. Should fears of a more serious economic slowdown resurface, markets would price a more aggressive cutting cycle and hence lower short-term yields. This central bank ‘put’ on cyclical risk is one of the reasons for our preference, among risky assets, for corporate credit and emerging markets.

Indeed, as the cutting cycle has started, the short end of yield curve is inverted (reflecting expectations of more cuts down the line), but the curve becomes positively-sloped from the five-year maturity point, as concerns about supply risk and sticky inflation become prevalent beyond that point. Between negative roll yields on the short-end, and term premium uncertainty on the long-end, this cup-shaped curve is wholly unappealing to investors.

Credit markets provide an antidote to this treacherous yield curve configuration. Indeed, the credit spread curve is positively-sloped across the maturity spectrum, and therefore enables investors to mitigate the negative slope in governments bonds, making the yield curve for corporate bonds much more attractive.

In emerging markets, we believe that the inauguration of a Fed cutting cycle will enable local central banks to cut rates more aggressively than currently priced. Real rates are too high for these economies where disinflation is more advanced than in developed markets.