ECB Expected to Follow BoC in Rate Cuts

D-Day at the ECB: A New Chapter in Monetary Policy

by Faruk Imamovic
ECB Expected to Follow BoC in Rate Cuts
© Getty Images/Ralph Orlowski

With the Bank of Canada (BoC) slashing its overnight lending rate, a significant shift in monetary policy is underway. This move marks the beginning of a notable policy divergence between the US and Canada, setting the stage for a widening spread between US and Canadian two-year yields. Historically, such a widening spread has been accompanied by a rise in the USD/CAD exchange rate, which is projected to approach 1.40 by the year's end.

The European Central Bank (ECB) is expected to follow suit with a rate cut of 25 basis points, reducing the Deposit Rate to 3.75%. The decision is likely influenced by declining crude oil prices and subdued inflation projections, allowing the ECB to adopt an easing bias while maintaining a data-dependent approach. This move aims to alleviate concerns that the cut is merely an "insurance" measure.

Market Reactions and Broader Implications

The announcement from the basparked a broad stock rally, driven primarily by exceptional performance in the US tech sector. This optimism extended into European markets as traders anticipated the ECB's rate cut. The broader bond rally, fueled by expectations of rate cuts from other G-7 central banks like the Bank of England (BoE) and the Federal Reserve (Fed), has already contributed to rising stock multiples.

Canada's BoC made a pivotal decision, becoming the first major developed market central bank to initiate an easing cycle. This decision was somewhat unexpected, as economists had predicted a potential rate cut in July. The tipping point for the BoC was the recent collapse in crude oil prices, which led to a reassessment of inflation trends. The BoC's statement highlighted a trend of easing inflation, reinforcing confidence in achieving the target range of 1-3%. Governor Tiff Macklem's comments further suggested a willingness to implement additional rate cuts, maintaining a cautious yet proactive stance.

Macklem's acknowledgment of potential policy divergence with the US underscores the likelihood that the Fed may not reduce rates as swiftly as the BoC. The BoC could implement up to three cuts in 2024, while the Fed is expected to delay any cuts until late 2024 or even 2025. This divergence is expected to drive the USD/CAD exchange rate higher in the latter half of 2024, particularly as Canada's household consumption slows relative to the US due to resetting mortgage rates in 2025.

BoC© X/OttawaCitizen

The Broader Economic Context

Recent weaker activity data in the US, aside from the latest strong services PMI headline, has brought traders back to the possibility that other central bank rate cuts might not be "one and done." This perspective is crucial as traders await signals from the ECB. Although the ECB is almost certain to reduce its Deposit Rate by 25 basis points, there are arguments, notably from ECB hawks, that this cut should serve merely as an "insurance" to reverse the final rate hike from September 2023. ECB President Christine Lagarde has emphasized a data-dependent approach, avoiding any pre-commitment to a specific rate path.

An easing bias is likely to be subtly incorporated into the ECB's communication, potentially through statements indicating that further cuts could occur if conditions permit. This middle-ground approach allows for flexibility, enabling the ECB to halt cuts if inflation or wage growth trends upward. A stronger signal towards a September rate cut, however, could trigger a dovish market response. Traders are likely anticipating a conditional easing signal, which may not significantly impact EUR OIS forward rates or the EUR.

Since early May, the USD has struggled to rally despite expectations of rate cuts from other central banks such as the BoC, ECB, and potentially the BoE. This stagnation is largely due to a series of soft US economic data points, including the April employment report, May ADP employment report, and employment sub-indexes of the PMIs and JOLTs April report. Only the weekly initial unemployment claims reports have remained stable. Today's weekly claims report will be closely monitored for any indications of a deviation from the recent range of 210,000-230,000 new claims. Weak labor market data, including tomorrow's May employment report, could accelerate the Fed's first rate cut, potentially moving it to late 2024. This outlook is more dovish than the current baseline, which anticipates no Fed rate cuts before 2025.

Navigating Uncertainty in Monetary Policy

The Fed's response to future economic conditions will heavily depend on inflation metrics such as CPI and PCE PI, rather than solely on labor market data. Despite a US unemployment rate (U-3) of 3.9%, indicating a tight labor market, any significant shifts in inflation or economic activity will influence the Fed's policy decisions.

The evolving landscape of global monetary policy presents a complex interplay of economic indicators and central bank actions. As the BoC leads the way with its recent rate cut, the implications for the USD/CAD exchange rate and broader market dynamics will continue to unfold. Traders and policymakers alike will remain vigilant, navigating the uncertain waters of economic forecasts and data-driven decisions.