Beyond Bulls & Bears

Fixed Income

ECB begins what may be a slow cutting cycle

The European Central Bank cut its key benchmark interest rate by 0.25%, while indicating that its future moves will depend on incoming financial and economic data. David Zahn, Franklin Templeton’s Head of European Fixed Income, shares why he thinks the ECB will likely move slowly and discusses the implications for investors.

The European Central Bank (ECB) concluded its June meeting with a decision to cut its key policy rate from 4% to 3.75%—the first downward move since a hiking cycle began in 2022 to combat inflation pressures that surged after Russia’s attack on Ukraine. Although the Governing Council cited a drop of 2.5 percentage points in Europe’s inflation rate since the hiking cycle peaked in September 2023, the bank’s outlook projects inflation will remain modestly above the 2% target in both 2024 and 2025.

In my view, the ECB’s decision is consistent with how monetary policy operates with a considerable lag of 12-18 months. A cut in June 2024 is likely to be felt in late 2025 or early 2026. In the central bank’s outlook, Europe’s inflation rate should fall to 1.9% at about that time. Although inflation is sticky, it is likely to trend down in the long term.

The decision was well telegraphed and expected by markets. Europe’s economy is doing well enough that policy does not need to become accommodative at a rapid pace. Although the largest economy in the region—Germany—has been slowing considerably, the rest of euro-area economy has been growing.

Although the ECB did not commit to any future moves, I believe it is embarking on a cycle that will ultimately take policy interest rates back to the neutral level of 2%—but at a gradual and deliberate pace. It is likely that we will see similar 25-basis-point cuts in September and December of this year. If the performance of the economy and inflation follow projections, we would probably see similar moves in each quarter of 2025, but this may not play out, of course. It’s important to remember we live in a world that has experienced many unexpected events in recent years, events that derailed policy expectations.

Gradual cuts may keep yields attractive

Investors should keep in mind that the ECB emphasized it would remain data-dependent as it considers future interest-rate decisions. This stance makes it likely that bond markets will react to new data as it is reported. As such, we expect European bond markets will remain in a range, in the short term, depending on whether the most recent data hints at higher or lower inflation. Current yields are in the middle of the recent range. With rates rangebound, we will watch for tactical opportunities.  However, longer term as the ECB cuts play out this will be very supportive for European bonds and should see bond yields decline.

The reduction in rates will start to impact money and will continue to decline at a gradual pace. Over time, should short-term rates fall as we believe is likely, investors may consider moving from money market funds to short-duration bonds as a way to maintain an attractive level of income.  This could create a new buyer base that will support fixed income markets going forward.

US policy remains on a separate timetable

We don’t see any implications in the ECB move for the US Federal Reserve. The Federal Open Market Committee meets June 11-12, but we think it is very unlikely to cut rates this month. The US economy continues to grow at a more rapid pace and is experiencing less fiscal drag than the euro area. Recent economic and inflation data suggest that the Fed could cut rates once or twice during 2024, but the decisions will result from domestic-focused concerns rather than a concern about matching the ECB cut.

 

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. 

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.

International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

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