Curmi & Partners

Europe Blinks First

Article By Nathan Sammut Mock

Recent economic data and statements from the European Central Bank (ECB) indicate that the ECB is poised to begin lowering interest rates at its upcoming meeting on 6th June. Markets are widely expecting a 25-basis point cut to 3.75% which would follow in the footsteps of the Swiss, Swedish, Czech, and Hungarian central banks who have all begun cutting their own key interest rates over the past couple of months. This anticipation is driven by a continued decrease in Euro-Zone core inflation (which excludes energy and food prices), now at 2.7%, and growing confidence among ECB members that sufficient progress is being made in lowering inflation to justify easing financial conditions.

The Bank of England (BoE) echoed similar sentiments during its monetary policy meeting on 9th May, signalling readiness to cut rates sooner rather than later, on the back of the encouraging developments in controlling inflation. Governor Andrew Bailey highlighted that the BoE might make monetary policy less restrictive over the forecast period, potentially more than current market rates suggest.

In contrast, the U.S. Federal Reserve (Fed) remains less forthcoming to rate cuts, at least for now. Since the turn of the year, the U.S. experienced three consecutive months of higher-than-expected inflation readings in Q1 2024. Consequently, the Fed has effectively had to scale back initial forecasts which suggested three interest rate cuts for 2024. Markets now anticipate that the Fed will cut less than two times this year, with most Federal Open Market Committee (FOMC) members emphasizing the need to maintain rates at the current level of 5.25% to 5.50% for longer.

Although the divergence in policy paths means we can expect the ECB and BoE’s key interest rates to head lower before the Fed, the path beyond Europe’s expected June cuts remains uncertain. The ECB has not committed to a specific timeline for additional rate cuts, despite forecasts suggesting euro-area inflation will fall to the target level of 2% by Q2 2025. ECB policymakers are maintaining a data-dependent approach, allowing flexibility for any abrupt changes in economic conditions and renewed volatility in future inflation prints. Additionally, the ongoing geopolitical conflicts which continue to persist, can have an impact on energy prices, particularly oil, and so developments on this front will need to be followed by central banks and financial markets alike.

Meanwhile, the broader economic context highlights differing growth trajectories between Europe and the U.S. The Euro Area shows signs of economic improvement, exiting recession with faster-than-expected growth in its top four economies in Q1 2024. However, overall output within the 20-country bloc remains lacklustre, with projected GDP growth of just 0.6% in 2024 and 1.5% in 2025. The U.K. is experiencing a similar tepid rebound after a shallow recession in the second half of 2023. Given the current data and despite the central banks’ reluctance to commit themselves, markets are pricing in more rate cuts to unfold in Europe by the end of year.

Conversely, the U.S. economy, despite its resilience, has started to show increasing signs of slowing down and in turn this may give the Fed more confidence to initiate its own monetary easing cycle towards the end of the year. This is evidenced by mounting economic data which has shown that annualised Q1 2024 GDP figures came in below consensus forecasts as it declined sharply to 1.6% (the lowest growth rate since the contractions in the US economy in H1 2022) while April’s ISM index on manufacturing activity fell short of expectations as it swiftly slipped back into contractionary territory. In addition, last week’s University of Michigan’s Survey of Consumer Sentiment Index hit a 6-month low as it came in far below market expectations and significantly lower than the previous month, citing consumer concerns that inflation, unemployment and interest rates may be moving in an unfavourable direction in the year ahead.

The Fed is now at a crossroad. On the one hand it could adjust its 2% inflation target higher, ease rates and therefore stimulate economic growth. On the other hand, it could maintain its 2% inflation target and keep rates higher for longer at the cost of economic growth. What is certain is that the Fed’s decision will likely play a key part in Europe’s future policy decisions, especially those in 2025. This is because any significant divergence in interest rates policies could continue to strengthen the dollar and therefore raise the cost of imported goods and services, particularly in the Euro-zone. Therefore, if the Fed doesn’t move, Europe will likely have to pause monetary easing earlier than expected.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.