The ECB’s Follow-Through Thursday

Shocking the financial world, the European Central Bank (ECB) defied its forward guidance and hiked its interest rates Thursday. KIDDING! They cut by 0.25 percentage point, doing what seemingly every tuned-in person on Earth expected, if the sea of commentary we have read in recent weeks is any guide. This follows the Bank of Canada’s (BoC’s) interest rate cut Wednesday, also widely expected amongst economists we follow. Naturally, the conversation in the broader financial commentary world has since turned to what comes next. We suggest tuning it all out—in our view, stocks have likely already weighed and priced this in.

For several weeks, investors have seemingly circled 6 June as ECB rate cut day. From our vantage point, this seems largely thanks to ECB President Christine Lagarde, who said after April’s monetary policy meeting that policymakers were likely to have enough data to support a rate cut in June.^[i] Most commentary we read on Canada’s cut—which met consensus expectations—couched it as a precursor to surefire ECB action the next day. So congrats, all, this is a rare occasion we have observed where monetary policy decisions actually matched forward guidance—monetary officials’ talk seeking to grant transparency into their expectations and thinking. That is a fresh change from when the ECB, US Federal Reserve (Fed) and other policymakers said rate steep hikes weren’t on the agenda in late 2021 or early 2022 … only to start hiking aggressively soon after.^[ii]

Markets seem rather unbothered about the whole thing. Canadian stocks rose a bit in local currency Wednesday, and eurozone stocks did the same in euros Thursday.^[iii] No earthshattering moves, just partial retracements of pullbacks that started last month.^[iv] Normal blips, in our view. Things many analysts and commentators projected happening actually happened, and the world seemingly moved on.

And, based on commentary we read, moved on to trying to guess what comes next. Not just for the ECB and BoC, but also for the Fed and Bank of England (BoE). You see, to most observers we follow, we are in terra incognita. Conventional wisdom says the Fed moves first and everyone else follows. Not because Fed policymakers are wiser and more daring, but because other countries supposedly want to avoid divergences that would cause currencies to wobble. But this hasn’t been true in practice, based on our study of monetary policy moves. The Fed often isn’t the first mover, making this episode far less of a curiosity than coverage implies.

Lagarde, BoC head Tiff Macklem, BoE Governor Andrew Bailey and Fed head Jerome Powell keep reiterating what we think is a key tenet: All these institutions make the decisions their committees deem best for their countries based on the data and forecasts at hand. The eurozone’s economy has had a rougher time than the US, and its inflation is lower, so Lagarde and friends cut.^[v] Macklem has stated the BoC sees higher interest rate risk for households in Canada relative to the US based largely on the far higher share of floating-rate mortgages, so he seemingly took advantage of inflation progress to bring some relief.^[vi] The BoE hasn’t cut, despite the UK enduring sequential GDP downturns in 2023’s second half, seemingly because policymakers are (wrongly, in our view) focused on wage growth.^[vii] Maybe they change course in two weeks or after July’s election—maybe not. Meanwhile, the Fed’s statements indicate it is waiting for more inflation progress.

Perhaps the Fed will factor into Lagarde, Bailey and Macklem’s thinking in the weeks and months ahead. Lagarde has acknowledged the euro’s exchange rate feeds into the ECB’s inflation projections, and our research finds all else equal, money flows to the highest-yielding asset.^[viii] Hence, we think interest rate changes matter for exchange rates.

But Fed rates were already higher than ECB and BoC rates before the cuts. The Fed-funds target range sits at 5.25% – 5.50%.^[ix] Meanwhile, the ECB cut its main refi rate from 4.50% to 4.25%, and the BoC from 5.0% to 4.75%.^[x] In our view, this is a large reason why the dollar was already trading near generational highs relative to a broad, trade-weighted currency basket.^[xi] Small cuts don’t much change the calculus, in our view, especially we find since policy rates are just one factor influencing currency moves.

Currency moves that we think are forward-looking, by the way—just like stocks. According to our research, all similarly liquid markets incorporate all widely known information, including monetary policy interest rate projections. When stocks, bonds and currencies see a high likelihood of a thing happening, we think they incorporate that thing into the price. We have seen it with corporate earnings downturns and recoveries on either end of bear markets, using S&P 500 stock returns and earnings data in FactSet for the long history.^[xii] We have seen it with US Treasury bond rates and Fed moves, with the former moving first the vast majority of the time.^[xiii] Simple logic holds that of these markets know something the others don’t. Many people trading in them could be the same!

Therefore, whatever the Fed, BoE and other monetary policy institutions do, we think markets have very likely already weighed it. This won’t necessarily prevent near-term volatility on meeting days, but it saps broader surprise power, in our view. If surprise hikes came instead of cuts there might be some bigger disruptions. But the whole conversation about cuts and timing seems beside the point to us. If an action is a foregone conclusion and markets pre-price expected events over the next 3 – 30 months, as our research finds they do, the timing seems inconsequential.

And, fundamentally, we have already seen economies and markets handle high rates. This global bull market started in October 2022, using stocks’ lowpoint in dollars, whilst monetary policy institutions throughout the West were still busy hiking and issuing more and more anti-inflationary rhetoric.^[xiv] All that persisted through the high-rate plateau.^[xv] US GDP continued growing through high rates.^[xvi] UK, eurozone and Canadian GDP had tougher sledding but returned to growth in Q1 despite high rates.^[xvii] To the extent rates were a headwind in some pockets of the economy, we think society has remembered how to deal and moved on—as we find it usually does.