The race to be the first major central bank to cut interest rates in 2024 is a contest no central bank really wants to win.
Sure, it would be a boon for stocks and represent a presumed victory in the fight against inflation. But the winner might well be dealing with a recession and possibly a weakening currency. The sequence and aggression of central-bank rate cuts will shape the path of global currencies in the year ahead.
Markets currently think the Federal Reserve will be first to lower borrowing costs, but the European Central Bank isn’t far behind. Indeed, the ECB was the market’s favorite for pole position before the Fed’s final meeting of 2023 in mid-December.
Lower interest rates typically diminish a currency’s relative value by making foreign investment less attractive. Thus, the late-2023 shift in expectations to favor the Fed as first mover helped the euro surge against the dollar.
The euro climbed more than 3% against the dollar in 2023, snapping a two-year losing streak. But the race to cut isn’t as close as markets think, which suggests the euro has further to climb in 2024.
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Traders now see the Fed cutting rates in March, while economists expect the ECB to take its first step toward lower rates in the second quarter. But that might be too soon for the ECB, which typically takes its time to make such big decisions. That is partly because it is responsible for interest rates in the 20 countries that use the euro, but also reflects the bank’s historic hesitancy about changing course—any course.
The ECB was slower than the Fed and the Bank of England to pause rate increases, hiking in September when the other two held steady. It was also the last of the trio to start hiking in July 2022.
“The ECB is a little bit like an oil tanker when it turns,” says Chris Turner, global head of markets at ING. “To hike rates and then cut them within six months feels a bit too early.” The third quarter of 2024 is more likely, he says.
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On paper there is a clear case for the ECB to be the first major central bank to lower borrowing costs. For starters, inflation in the euro zone is getting close to the bank’s 2% target, after falling to 2.4% in November—the lowest level in more than two years.
U.K. inflation stands at 3.9% on an annual basis, and U.S. inflation is at 3.1%. Both inflation rates are higher than their respective nations’ central banks would like.
Data released on Dec. 20 showed that U.K. inflation fell sharply in November, from 4.6%. That increased the chance of the Bank of England cutting rates sooner, but, for now, it is still behind the Fed and the ECB in the pecking order.
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The weakness of the European economy is another factor pointing toward an ECB cut sooner rather than later. Euro-zone gross domestic product contracted 0.1% in the third quarter, leaving the economy on the brink of a recession—defined as two consecutive quarters of negative growth. Germany, Europe’s largest economy, is expected to fall into recession this winter.
The U.K. economy fared marginally better, stagnating in the third quarter. U.S. GDP surged 5.2% in the same period.
Based on those metrics, it is easy to understand why some in the markets think the ECB could be the first to cut. And that’s despite the fact that ECB President Christine Lagarde recently said it isn’t time to “lower our guard,” and that between hiking and cutting there is a “plateau” of holding rates steady. Her comments have been largely ignored.
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The extent of the cuts may be even more important than the timing. Turner sees the Fed ultimately embarking on a larger easing cycle than the ECB, which will be negative for the dollar and marginally supportive for the euro. The bloc’s economic woes might prevent it from being a bigger winner from dollar weakness.
Nonetheless, ING’s forecast is for the euro to reach $1.15 by the end of 2024, a 4% jump from its 2023 year-end price. The average target among 48 economists polled by FactSet is for $1.12 by the end of ’24.
Even if the ECB breaks free of its trademark inertia and cuts rates as early as March, that doesn’t automatically spell a period of weakness for the euro, particularly if its easing campaign is more sluggish than the Fed’s.
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To a certain extent, the euro’s relative weakness protects it from falling further. “The euro is currently at historically low levels versus the dollar, partly due to weak economic data through the summer. This means a lot of weakness is already priced in,” says Joe Tuckey, head of foreign-exchange analysis at Argentex Group.
If Germany can turn a corner on growth, the euro can still strengthen despite the path of rate cuts, he adds.
The ECB’s cautious approach to cutting rates could see the euro follow up 2023’s strong showing with another good year in 2024.
Write to Callum Keown at [email protected]
