Monetary policy divergences between the ECB and the Fed
27 MAY, 2024
How much ECB and Fed rate cut cycles can actually differ? A lot, would be our answer. Ultimately, macroeconomic fundamentals matter - the US economy has been and likely will remain much stronger than the Euro area one, in terms of growth and inflation. Ultimately, that will drive divergence, although hesitation and structural inflation tolerance (higher at the Fed than at the ECB) could create delays.
How much divergence in the macro base case?
Fundamentals make for a lot of policy divergence. In our base case, we expect one 25bp cut from the Fed this year (in Dec) vs 75bp of ECB cuts in total (Jun, Sep, Dec). We expect more of the same in 2025, with 100bp of Fed cuts vs 125bp from the ECB, and possibly a continuation of the theme in 2026. If hesitation matters, then perhaps on the timeline. We expect the ECB to have cut to 2% by July 2025, ie one-cut-per-meeting next year. Perhaps the Fed trajectory can create delays here - it might take until late-25 for the ECB to get back to 2% depo rates (inflation will have been below 2% for a year then), but our conviction level that we will get there, eventually, is high.
Consecutive cuts?
While we do not see consecutive cuts in June and July as realistic, we are not willing to rule out another cut in October. Why? The ECB is making a clear distinction: the next decisions are about moderating the pace, not necessarily about initiating a cutting cycle per se. This is the kind of two-stage decision process we have been pointing to. The first concerns whether policy can be made somewhat less restrictive, i.e. the beginning of the ‘moderation’ phase. That is what June is all about, as well as the meetings immediately after June. And then, after a while, they can decide whether and how fast they go to the stalemate (or further down if they take too long to be convinced). To us, this is not consistent with the ECB cutting at consecutive meetings unless the data forces them to do so. Therefore, we see little chance of another cut in July.
Back-to-back cuts require some sense of urgency. This may come either from a much weaker growth outlook than we all expect, or from the realisation or conviction that inflation remains below target. Hence the acceleration of the tightening cycle in December. But we cannot rule out the possibility that the September ECB staff forecast already incorporates with some conviction this undershoot, opening the door to that additional cut in October relative to our baseline scenario. The quarterly bank lending survey to be released days before the October meeting could provide additional justification for such a cut if it shows an intensification of the transmission of monetary policy tightening to lending conditions.
How much divergence can the market price?
Overall, we think that the (realistic) additional divergence we could get from the Fed and ECB in 2024 would be at most 50 basis points higher than what we have in our current baseline scenario. Would this be realistic or could market forces prevent them from diverging that much?
At this stage markets are pricing 30bp of policy rate differential at the end of this year vs 50bp in our base case. The room for market repricing seems even larger for next year. Eventually, that should make for wider 10y UST vs Bund spreads - we expect 225bp at the end of this year and close to 250bp by end-25. The room for market adjustment is ample but the path there will be long. It will take a steady flow of data consistent with this view for markets (and the ECB) to get around to that, we think. In other words, we understand investor hesitation to trade this view at this stage.
Our conversations with investors suggest that most find it difficult to envisage 3 ECB cuts this year without the Fed signalling a first cut by the end of the year. This is consistent with the 50 basis point maximum spread set in April. However, this narrative may change depending on exchange rate developments.
Is EURUSD a risk to that scenario?
It would likely take a lot of EUR depreciation for the exchange rate to prevent Euro area inflation to get back to 2% by end-24 and further below. But that is not our base case. With market pricing at least for this year not far off our base case, central bank divergence should largely be reflected in the exchange rate already today. As economies normalise and return to the equilibrium, EURUSD should do, too. And the reference for equilibrium remains at 1.20, in our view. Consequently, a gradual return towards (although not quite all the way to) these levels through 2025 remains our base case, and a stark EURUSD move lower (towards parity) a risk scenario. It would probably require pricing out any Fed cut this year and next, or renewed hikes, or another substantial energy price shock, for example.
