Article

Who will jump first on interest rates?

In the race to interest rate cuts, The ECB may end up as the first to the finishing line, while the US and the UK are more difficult to call. Patrick Farrell explores the possible outcomes.

| 6 min read

The fortunes of the major global economies are increasingly diverging. The latest Eurozone GDP data showed little or no growth in the region. The UK economy tipped into recession in the last few months of 2023, with an anaemic revival in January. In contrast, the US recorded GDP growth of 3.2% in the final quarter of 2023 with a ‘hard landing’ – in fact any landing at all - looking increasingly unlikely.

This may open up an increasing gap on inflation. The latest US CPI data showed core inflation marginally higher than expected, fuelled by higher energy and ‘shelter’ costs (including rents, hotel and motel stays). In contrast, Eurozone inflation is already down to 2.6% and core inflation is also slowing, even though the ECB started monetary tightening three months later than the Federal Reserve. In the UK, inflation is currently at 4%, but is expected to dip sharply over the next few months.

It may also open up a gap on interest rates. To date, each of the major central banks has been tracking the Federal Reserve, but there is a chance that policymakers diverge as their economic paths move apart.

What is the data suggesting on the outlook for interest rate cuts?

1. Eurozone

The Eurozone economy has been held back by its manufacturing base, particularly in Germany. Industrial production has been extremely weak. While German industrial output appears to be bottoming out (having fallen 5.5% in 2023) other areas are still flailing. Across the wide Eurozone, overall industrial production fell 3.2% in January, against expectations of a fall of 1.8%.

This is likely to be a key metric for the European Central Bank, and could prompt them to move on rates earlier than any of the others. ECB Council member Olli Rehn said that the group had already started to discuss rate cuts, and implied that a rate cut was plausible ahead of the summer.

Another persuasive factor for the ECB may be that European corporates tend to access financing through the banks rather than the capital markets. They are therefore in thrall to lending decisions from the banks, and they have been strict in their criteria. This has made it more difficult for some smaller or higher risk companies to access financing.

China had previously absorbed a lot of Europe’s manufacturing output, including luxury goods and autos. Deteriorating US/China relations have put those revenues in jeopardy. ASML, for example, announced that it would halt hi-tech chip-making exports to China in January of this year. High growth businesses such as ASML can find other sources of growth, but this is not universally possible.

2. The UK

For the UK, the impact of higher interest rates will continue to bite for the next 12-18 months, even if mortgage resets won’t be as painful as they could have been six months ago. Banks introduced lower interest rates at the start of the year, which has provided a relief valve for the UK economy and gives the Bank of England some flexibility to maintain rates at their current level.

The economic data showed a small improvement in January. The UK emerged from its brief recession and delivered growth of 0.2%. There has also been a lot more stability in the bond market, which creates a better situation for households. While there are still pressures, the Bank of England may want to take a wait-and-see approach to rate cuts for the time being.

In particular, wages in the services sector are still running at too high a level. There have been a series of labour disputes and the central bank is likely to want to squash that out of the system before risking a rate cut. Our view is that rates may be held higher, even though the economic situation appears precarious.

3. The US

In the US, GDP growth is high. Nevertheless, there are pressure points. Inflation has not come down as much as the central bank would have hoped, and areas such as rental costs, insurance, gasoline and freight are keeping the CPI high.

Another looming problem may be non-mortgage interest costs. These are now just as high as mortgage interest costs. Credit card debt is at over $1.1 trillion and represents one-fifth to one-quarter of non-mortgage US debt. For the time being, delinquency rates are low. Only 1.4% of credit card holders haven’t paid their bill for more than 30 days. However, it is a source of vulnerability for the economy.

At the moment, low effective interest rates on mortgages have contributed to this low delinquency rate. People haven’t sold their houses, or renegotiated their mortgages and are locked in to low 30-year rate mortgages. The variable rates that are associated with credit cards, auto loans, student loans and other private loans, are likely to impact on household cash flows more than mortgages. While people still have jobs, they will be happy to service the interest cost, but it’s a potential risk to economic stability.

The Federal Reserve may look at this when making its decision. It will also be aware that the longer interest rates remain high, the greater strain it puts on government financing. The US is already paying away around 15% of its tax receipts on debt servicing.

In the race to cut rates, the ECB may end up as the first to the finishing line. The US and UK are more difficult to call, and it may depend on the data over the next few weeks. An equally important question will be whether one cut galvanises the others into action.

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