The first phase of the waltz

At the end of March, the Swiss National Bank inaugurated the ball on interest rate cuts, before being joined, at the start of May, by its Swedish counterpart, the Riksbank. Yet up until now, the heavyweight central banks in developed countries had shunned the dance floor. This is no longer the case, with two institutions taking their first steps in the waltz this week. The Bank of Canada (BoC) pulled the rug out from under the European Central Bank, becoming the first central bank in a G7 country – by a single day – to cut its rates in this cycle.

Yet although these two central banks made cuts of the same amount – both reducing their principal key rates by 0.25% – they could follow very different trajectories in the coming months. BoC Governor Tiff Macklem left the door open for further rate cuts in the coming months. This is clearly justified by the domestic economy, with headline inflation numbers having fallen below the top end of the BoC’s target range several months ago. At the same time, unemployment has risen, reaching 6.1% in April versus 5.1% a year earlier, whilst GDP growth for Q1 2024 was a modest 0.5% year-on-year, and consumption is stagnating.

In Europe, things are less clear cut. The ECB proceeded with its widely heralded initial interest rate cut, but at the same time raised its inflation outlook for 2024 and 2025. Christine Lagarde was unable to provide a clear explanation for this apparent inconsistency, which leaves investors in the dark about the speed of further interest rate cuts from the ECB in the next few quarters. Here again, the economic situation justifies this lack of visibility. Disinflation in the eurozone has been quite swift but services inflation remains high. Wage inflation is showing some signs of stagnation at overly high levels and the cycle looks to be ramping up again from the low point reached in the second half of 2023.

Diverging economic scenarios are resulting in quite distinct tempos for the monetary policy waltz, and this phenomenon is not restricted to a comparison of Canada and Europe. In the UK – where a first rate cut in June had been the central scenario for a while – the cards have been reshuffled by adverse inflation figures in April. In parallel to this, wage inflation is still running at a very high level and showing few signs of subsiding, in contrast to what we are seeing in other developed countries. Furthermore, although economic activity is holding up at a satisfactory level across the Channel, household consumption remains weak and employment has contracted considerably in recent months. The outlook is hardly clearer in Australia, where the markets are not expecting any cuts for 2024, as inflation has reaccelerated in recent months whilst Q1 growth remained lacklustre and household spending collapsed. And we won’t linger on the case of Japan, whose monetary policy is completely out of step with other developed countries, with the first interest rate hike in March and two further rises expected by the end of the year.

These regional distinctions are likely to mean that central banks will certainly waltz together, but each to their own beat. Yet for markets, it is the tempo of the US waltz that will be of most importance. The expectations of market participants for the trajectory of moves from the Federal Reserve (Fed) have rarely been so disparate – some are still expecting the first cut in July, whilst several are banking on the following months, and others are no longer expecting any cuts in 2024. Yet it may well be in the US that we see the strongest visibility in the near term. Inflation figures were reassuring in April, after negative surprises in the first quarter, price rises are now only being fuelled by a few items with little correlation to demand, growth was significantly below expectations in Q1, and the employment market is gradually deteriorating – if this economic outlook is confirmed, it could indicate a clear path for the Fed.

Today, there is still room for detours before joining the waltz of rate cuts, but there is little doubt that central banks in other developed countries will eventually follow in the wake of the BoC and ECB and join them on the dance floor. Whether the tempo is three, four, twenty or one hundred beats, the consequences will be radically different for investors.

Final version of 7 June 2024 – Enguerrand Artaz, Fund Manager, LFDE