If the central banks in Europe and the United States do not cut interest rates this year?

Wallstreetcn
2024.01.26 10:42
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Bank of America believes that the interest rate cuts by central banks in Europe and the United States may be much lower than market expectations. If the market expectations are not met, the US dollar may benefit in the short term.

As the market continues to assess "how quickly will the central banks in Europe and the United States cut interest rates," Bank of America analysts have raised an interesting question: What would be the market reaction if the central banks in Europe and the United States do not cut interest rates this year?

In a recent report led by Athanasios Vamvakidis, Bank of America strategists pointed out that if the market's expectation of significant interest rate cuts by the central banks in Europe and the United States this year does not materialize, the US dollar, euro, and Swiss franc would rise, while the Australian dollar and Japanese yen would come under pressure.

The Bank of America strategists noted that it seems like a "pipe dream" that the central banks in Europe and the United States would not cut interest rates this year, given the market's widespread expectations. However, they find it puzzling that the market has priced in such aggressive interest rate cuts for this year.

Currently, the market believes that there is a 90% chance that the European Central Bank will start cutting interest rates in April, with an expected total cut of 141 basis points for the year. The probability of a rate cut by the Federal Reserve in May has already exceeded 90%, with an expected total cut of 150 basis points for the year.

Bank of America believes that although they also expect the central banks in Europe and the United States to start cutting interest rates this year, the magnitude of the cuts will be much lower than the market expects. They predict that the Federal Reserve will cut rates four times, while the European Central Bank will cut rates three times:

If the rate cuts happen later than the market expects, the US dollar, euro, and Swiss franc may benefit in the short term.

Bank of America: Rate cuts may not start immediately

Bank of America points out that the end of rate hikes does not necessarily mean that rate cuts will start immediately. Officials from the Federal Reserve and the European Central Bank have been continuously signaling to the market to dampen expectations of rate cuts, emphasizing that they will further observe more economic indicators and maintain higher interest rates for a longer period of time.

Bank of America believes that the monetary policy of the central banks in Europe and the United States will be mainly influenced by three factors, given the resilience of the labor markets in both regions:

First, the risk of excessive tightening: If interest rates remain high for too long, it will further exacerbate systemic financial risks and potentially trigger a financial crisis similar to the banking crisis. The longer interest rates remain high, the greater the accumulated risks, which will force the Federal Reserve to shift its monetary policy and possibly restart liquidity easing measures such as quantitative easing (QE).

Second, inflation factors: If the inflation level in the United States, especially the core inflation rate, rebounds or remains high, the Federal Reserve will find it difficult to start cutting interest rates and may instead maintain rates for a period of time. However, if inflation continues to decline, the central banks will have to start cutting rates to avoid further tightening of real policy rates. "In our view, this is the most likely explanation and is consistent with Powell's recent views."

Third, economic growth factors: However, the performance of risk assets has not reflected these concerns. We believe that monetary tightening primarily affected inflation expectations in 2023, but starting this year, it may have a greater impact on the real economy, which the market seems to be "unconcerned" about. From the above three points, Bank of America pointed out that central banks around the world should proceed with caution and wait for more data to confirm that inflation will continue to decline this year. Overall, there is still a rebound trend in inflation, so central banks may cut interest rates later than market expectations.

Market is too optimistic, if interest rates are not cut, the US dollar will strengthen

Bank of America believes that the market does not differentiate enough between G10 countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom, and the United States) in terms of inflation data and interest rate cuts:

The correlation between the two should be: the lower the inflation, the more interest rate cuts. However, this correlation is now almost zero. Some central banks may eventually reduce the magnitude of interest rate cuts, and the divergence of data between central banks will support the US dollar and the Swiss franc.

From the extreme results, if central banks of G10 countries do not cut interest rates this year, the US dollar, euro, and Swiss franc will perform the best, while the exchange rates of Norwegian krone, Australian dollar, and Japanese yen will come under pressure:

The US dollar will perform the best, consistent with the current tightening cycle, and risk aversion will weigh on G10 currencies with high beta coefficients. As monetary policy converges with current market pricing, the Japanese yen will also weaken. The euro will also receive support.

Returning to the possible scenario, if the timing of interest rate cuts is later than market pricing, Bank of America believes that the US dollar may strengthen in the short term.