Will an ECB Cut be the Catalyst That Moves Currency Markets?

The European Central Bank has signaled that it will cut interest rates at its meeting this week, potentially starting a proper cutting cycle ahead of the Federal Reserve for the first time since the ECB’s inception in 1998. The ECB’s messaging generated some market excitement about a widening interest rate differential and its impact on currency movements. If the ECB cuts rates while the Fed holds steady, could it finally drive euro weakness after 18 months of range-bound trading?

We don’t think it’ll be quite that simple. While rate differentials matter, we see a couple of factors that could maintain the status quo in currency markets even if the ECB cuts.

The glide path to 2% is far from assured

At this point, we think only a dramatic development would prevent the ECB from following through with a cut in June. After the bank’s insistence on “data dependence,” growth is weak and inflation is decelerating. Even the upside surprise in the recently released Q1 negotiated wage data appears to have had limited impact on market expectations for a cut in June. However, the ECB has intentionally, and notably, provided little guidance on future cuts.

A protracted ECB cutting cycle is not a given. Europe is facing some lingering uncertainties that may prevent a smooth glide path for inflation and policy rates back toward neutral. These include potential improvement in the economy, elevated unit labor costs, geopolitical uncertainty and fiscal policy. Heightened uncertainty and aggressive rate cuts could raise fears of a policy error, which threatens central bank credibility.

In our view, ECB uncertainty makes it difficult to forecast a strong widening of interest rate differentials between Europe and the US.

Destination and dispersion

Current market pricing reflects an ECB rate cut in June and a Fed cut in November of this year. While the timing and sequencing has changed, the destination—the expected interest rate differential over the coming year or two—has not moved dramatically. Longer-term expectations for interest rate differentials are an important factor for exchange rates.

In fact, global central bank expectations are generally quite dispersed. Many emerging market central banks, the Swiss National Bank, and Sweden’s Riksbank have already initiated their cutting cycles, Australia and New Zealand could trail the Fed and Japan is priced for rate hikes. This dispersion has contributed to performance differentiation between currencies, but the US dollar has remained among the top performers year to date. Combining destination and dispersion, market pricing implies the Fed is expected to have one of the highest policy rates in the G10 group of nations.

The Fed drives a range-bound US dollar

Through all the shifts in market pricing, Fed policy expectations have been the dominant driver. The US currently offers higher-yielding government bonds and a perceived “safe haven” currency. While the Citi US Economic Surprise Index has recently underperformed versus Europe and China, meaning Europe and China have had more upside surprises in economic data, we believe US “exceptionalism” remains a market theme.

Broad uncertainty and lower levels of conviction have been features of the markets recently. Macro factors, from global growth, China and geopolitics, to debate around the Fed, Treasury yields, and US growth and inflation, have supported the US dollar but also contained it to a wide range. To break the stalemate, we think markets will need more clarity on the path of the Fed and growth in Europe and China.

WRITTEN BY:

Hank Lynch, CFA, Global Strategist, Global Fixed Income Team

Marianne Winkelman, Director of Global, Rates, EM & FX Trading

SAIF0p72x0e0

Commodities, interest and derivative trading involves substantial risk of loss. 

Any investment that has the possibility for profits has the possibility of loses, including the loss of principal.