Expected rate cuts overseas unlikely to be start of global easing, says BlackRock

Inflation has fallen a long way from pandemic-era peaks but the share market may struggle to take a new bullish signal from the expected start of rate cuts in Canada and Europe this week.

All eyes will be on world markets if as expected Bank of Canada and the European Central Bank begin to cut rates. Picture: AFP

Interest rate cuts are widely expected to start in North America and Western Europe this week.

Inflation has fallen a long way from pandemic-era peaks and inflation expectations are well anchored. But will cuts this week trigger another leg up in shares after strong gains this year?

Central banks lifted rates at the fastest pace in decades as inflation took after the pandemic. Now Bank of Canada and, more importantly, the European Central Bank are set to cut their policy rates by 25 basis points, mainly because inflation has fallen sharply from pandemic era highs.

But slower-than-expected progress toward central bank inflation targets this year has resulted in interest rate cut expectations being wound back. That hasn’t stopped developed markets’ stocks hitting record highs, helped by US economic resilience and AI euphoria emanating from US tech giants.

Although weaker-than-expected US manufacturing data in recent days has started to fuel jitters about the US economy that have pushed US Treasury yields down for the “wrong” reasons as far as the stock market is concerned, there’s still a lot of hype in market valuations which could be affected in the short term by the guidance from the BoC and more so the ECB.

Given that their inflation rates are still about 0.5-1 percentage points above their target levels, economists expect rate cuts this week to be accompanied by suitably cautious guidance.

As is the current thinking for most central banks, ANZ says the ECB won’t wait for inflation to exactly meet its target before cutting interest rates. To do so would risk undershooting its inflation target in the medium term due to the current level of policy restriction in terms of the real policy rate of 1.6 per cent versus the ECB’s estimate of the longer-run neutral real rate which it pegs at zero.

Similarly, ANZ expects that over the course of its interest rate cutting cycle, the ECB will cut rates by 200 basis points to avoid undershooting the inflation target over the medium term.

But given the current “bumpy” nature of disinflation, the ECB is expected to indicate that future rate cuts will be data dependent and determined on a meeting-by-meeting basis.

“The current reality is that inflation is still above target and may bounce around over coming months before settling in 2025,” ANZ head of G3 economics Brian Martin said. “Near term, monetary easing is not on a preset course given the current bumpy nature of disinflation.”

Hints of rapid-fire interest rate cuts are rare in any case. Current market pricing implies a relatively modest two to three rate cuts of 25 basis points by the ECB and BoC by year end. ANZ has pencilled in another ECB cut in July but is waiting for the ECB’s updated economic forecasts this week.

“We are not in the camp that the ECB is ‘one and done’ and we expect the ECB will cut interest rates by 200 basis points over the coming cycle, bringing the real policy rate to zero,” Mr Martin said.

“We think the ECB must address the danger of running an overly tight policy that could risk a persistent undershoot of inflation in the future.”

However, BlackRock strategists see inflation limiting how much central banks can cut interest rates.

In their view an ECB cut this week is unlikely to be the start of a meaningful global easing cycle.

“Major central banks are gearing up to cut interest rates, but like their hiking cycles, this cutting cycle will be far from typical,” said BlackRock Investment Institute head Jean Boivin.

European government bond yields have swung as markets question how far the ECB will ease policy beyond a first cut expected this week – falling inflation and 18 months of weak economic activity make the case for the ECB to start cutting rates, but BII doesn’t think it will cut “far and fast”.

As with its view on the Fed, BlackRock sees just one or two rate cuts by the ECB this year.

“This is not your typical rate cutting cycle,” Mr Boivin said.

“Central banks are set to keep rates above pre-pandemic levels due to persistent inflationary pressures – and last week’s euro area inflation data again showed stalling inflation progress.”

Unusually, the ECB is readying to cut when growth is improving, inflation is above its 2 per cent target and the unemployment rate is at a record low. It’s a far cry from the economic crisis and “lowflation” of the past decade that spurred the ECB to introduce negative interest rates and buy bonds at scale.

In another unconventional step, the ECB is on the verge of easing before it’s certain what’s next for US monetary policy.

With US inflation proving volatile and services inflation especially elevated, another rate hike is not entirely off the table.

This means that in the short term, the gap between Fed and ECB policy rates could widen and weigh on the euro against the US dollar until the Fed starts cutting rates.

But BlackRock thinks both central banks will “ultimately keep rates high for longer”.

This is not a consensus view. Morgan Stanley predicts 175 basis points of US rate cuts by the end of 2025.

But BlackRock expects policy rates in the US and Europe settling at a far higher level than they were pre-pandemic, due to “mega forces” affecting inflation.

“We don’t see euro area inflation falling below 2 per cent as it did when central banks cut rates before 2020,” Mr Boivin said. “That’s because we are in a world shaped by supply constraints – a reality ECB officials have acknowledged recently.”

He warns of long-term structural shifts, including geopolitical fragmentation, demographic divergence and the low-carbon transition, which are also playing out in the US.

“As a result, we expect ongoing inflationary pressures and structurally lower growth than in the past across major economies,” Boivin added.

ECB rate cuts and recovering euro area economic growth should favour European stocks, but BlackRock prefers US stocks for the next 12 months as they are at the epicentre of the AI boom.

But in fixed income the fund manager likes the higher total yields on offer in euro area credit. It thinks improving growth in the euro area could also limit any spread widening relative to the US.

Euro area government bonds will be better supported than US Treasuries according to BII.

Euro area rules limiting budget deficits now apply again after being suspended during the pandemic, even with 11 countries currently exceeding the deficit limit of 3 per cent of GDP.