The ECB’s Follow-Through Thursday

Shocking the financial world, the European Central Bank (ECB) defied its forward guidance and hiked rates Thursday. KIDDING! They cut by 0.25 percentage point, doing what every tuned-in person on Earth expected. This follows the Bank of Canada’s (BoC’s) cut Wednesday, also widely expected. Naturally, the conversation has since turned to what comes next. We suggest tuning it all out—stocks have already chewed this over to death.

For several weeks, investors have circled June 6 as ECB rate cut day. Futures markets pointed to it. So did ECB head Christine Lagarde, who said after April’s meeting that policymakers were likely to have enough data to support a rate cut in June.^[i] Most commentary on Canada’s cut—which met consensus expectations—couched it as a precursor to surefire ECB action. So congrats, all, this is a rare occasion where monetary policy decisions actually matched forward guidance. That is a fresh change from when all these folks said rate hikes were off the table in early 2022 … only to start hiking aggressively soon after.

Markets seem rather meh about the whole thing. Canadian stocks rose a bit Wednesday, and eurozone stocks did the same Thursday. No earthshattering moves, just partial retracements of pullbacks that started last month. Normal blips, in our view. Things everyone expected to happen actually happened, and the world moved on.

And 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 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 want to avoid divergences that would cause currencies to wobble. But this hasn’t been true in practice, as we showed a couple months back. The Fed often isn’t the first mover, making this episode far less of a curiosity than coverage implies.

The simple truth is one Lagarde, BoC head Tiff Macklem, BoE Governor Andrew Bailey and Fed head Jerome Powell keep reiterating: 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 (largely because it doesn’t factor in owner’s equivalent rent), so Lagarde and friends cut.^[ii] Macklem saw higher interest rate risk for households in Canada relative to the US based largely on the far higher share of floating-rate mortgages north of the border, so he took advantage of inflation progress to bring some relief. The BoE hasn’t cut, despite the UK enduring sequential GDP downturns in 2023’s second half, seemingly because policymakers are wrongly focused on wage growth. Maybe they change course in two weeks or after July’s election—maybe not. Meanwhile, the Fed 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 all else equal, money flows to the highest-yielding asset. Hence, 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%. Meanwhile, the ECB cut its main refi rate from 4.50% to 4.25%, and the BoC from 5.0% to 4.75%.^[iii] This is a large reason why the dollar was already trading near generational highs relative to a broad, trade-weighted currency basket. Small cuts don’t much change the calculus, especially since policy rates are just one factor influencing currency moves.

Currency moves that are forward-looking, by the way—just like stocks. All similarly liquid markets incorporate all widely known information, including central bank rate expectations. When stocks, bonds and currencies see a high likelihood of a thing happening, they incorporate that thing into the price. We have seen it with earnings downturns and recoveries on either end of bear markets. We have seen it with bond rates and Fed moves, with the former moving first. None of these markets know something the others don’t. The people trading in them are often the same people!

Therefore, whatever the Fed and its international bedfellows do, markets have very likely already weighed it. This won’t 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, the timing seems inconsequential.

And, fundamentally, we have already seen economies and markets handle high rates. This global bull market started in October 2022, while central banks were still busy hiking and screeching more and more anti-inflationary rhetoric through their hawkish beaks. All that persisted through the high-rate plateau.^[iv] US GDP continued growing through high rates. UK, eurozone and Canadian GDP had tougher sledding but returned to growth in Q1 despite high rates. To the extent rates were a headwind in some pockets of the economy, society has remembered how to deal and moved on—as it usually does.