News of the week summary - 06/02/2024

ECB to cut interest rates next week

The European Central Bank's (ECB) chief economist, Philip Lane, has indicated the bank will likely reduce interest rates from their historic highs next week. Investors expect the ECB to cut its benchmark deposit rate by 0.25 percentage points from the current 4%, following a decline in Eurozone inflation to near the bank’s 2% target in the past months. This decision marks a significant shift for the ECB, which had faced criticism for being slow to raise rates during the recent inflation surge.

Major economies like the US, UK, and Japan are not expected to follow suit immediately. Inflation in the Eurozone has decreased more rapidly than in the US, largely due to Europe’s severe impact from the energy crisis. Lane highlighted that while a rate cut would indicate effective monetary policy, the ECB must maintain restrictive rates throughout the year to ensure inflation continues to decline and doesn’t stabilize above target levels.

Despite a recent rise in Eurozone inflation to 2.6% in May, policymakers remain optimistic about the scheduled rate cut. Some ECB members downplayed the inflation uptick, suggesting it doesn’t significantly deviate from expectations. However, the increase in core inflation, which excludes volatile energy and food prices, could influence the ECB’s cautious stance on further rate reductions this year. While the initial rate cut is likely, subsequent cuts in July appear less certain given the current inflation trajectory and economic conditions.

The market reaction has been notable, with Germany’s 10-year bond yield climbing to its highest level in over six months. 

IMF improves China’s growth forecast, calls for shift in economic policy

In its latest assessment, the IMF has increased its GDP growth forecast for China in 2024 from 4.6% to 5%, and for 2025 from 4.1% to 4.5%, due to stronger-than-expected growth in the first quarter and new policy measures aimed at mitigating a severe property market slump. China's government has also set a growth target of around 5% for 2024, mirroring last year’s target, which is the lowest in decades.

The IMF recommends that China restructure its economy away from inefficient industrial policies that support "priority sectors" and instead focus on boosting domestic consumption. This involves reducing trade and investment restrictions, which the IMF believes would enhance domestic productivity.

The IMF’s call for policy change comes amid concerns from China’s trading partners that its industrial policies are creating overcapacity in sectors such as vehicles and renewable energy. The IMF warned that these policies could lead to a misallocation of resources and have adverse effects on global trade. Indeed, this strategy has sparked trade tensions, with the US imposing tariffs on Chinese electric vehicles and the EU conducting an anti-subsidy investigation into Chinese automotive imports.

Despite the positive report, China's manufacturing sector contracted unexpectedly in May, with the purchasing managers’ index (PMI) falling to 49.5, indicating a decline compared to the previous month. This contrasts with April's industrial production, which exceeded expectations with a 6.7% rise.

Despite some government measures, such as allowing state-owned enterprises to purchase unsold housing, the property market remains weak, with new home sales dropping 23.4% year-on-year in the first quarter. Retail sales growth also lagged at 2.3% in April, underscoring tepid consumer demand.

Sterling trading at a near 2 year high against the Euro

The British sterling has climbed to its highest level against the euro in 21 months, driven by persistent inflation in the UK and diminishing expectations for near-term interest rate cuts by the Bank of England (BOE). This rise underscores how short-term interest rates are currently a key determinant in foreign exchange markets.

The pound is trading at £0.85 per euro, a peak not seen since August 2022. Since the beginning of the year, sterling has appreciated by 2% against the euro. This trend is attributed to investors' growing belief that the BOE will delay cutting interest rates longer than the ECB.

The UK's economic performance has exceeded many forecasts, bolstering sterling. Persistent inflation concerns have reinforced the likelihood of the BOE maintaining higher interest rates for an extended period. Although UK inflation recently fell to a three-year low of 2.3%, the services component, a key indicator of underlying price pressures closely monitored by the BOE, stood at 5.9%, much higher than economists anticipated.

As a result of these inflation dynamics, markets have almost entirely ruled out a BOE rate cut next month. This marks a significant shift from early last week when the probability of a rate cut was still being debated. In contrast, the ECB is expected to begin lowering rates next week (see first article of this newsletter).

Political factors are also influencing the sterling's rise. The prospect of an imminent election (announced by current Prime Minister Sunak) and potential government change is seen positively by investors, who hope it will reduce political uncertainty that has previously weighed on the currency.

S&P lowers its rating of French debt

S&P Global has downgraded France's long-term rating from AA to AA- with a stable outlook, a significant blow to President Macron. This move reflects concerns over France’s rising debt-to-GDP ratio, which S&P predicts will increase through 2027 rather than decrease as previously expected.

The downgrade is driven by S&P's worries about France's slower-than-expected growth and the challenges posed by political fragmentation, which complicates the government's ability to implement growth-boosting and budget-balancing reforms. Despite the downgrade, France's borrowing costs are not expected to rise significantly, as investors continue to view it as a reliable investment. The spread between German and French 10-year bonds has slightly narrowed this year, but France still attracts buyers for its debt in the market. Nonetheless, it could have substantial political repercussions for Macron, especially with the upcoming European elections where his center-right alliance is trailing significantly behind Marine Le Pen's far-right party.

While unemployment has dropped to its lowest levels in decades and foreign investment has increased, heavy public spending has continued, resulting in a ballooning deficit and national debt. France’s deficit was wider than expected last year, at 5.5% of GDP compared to a forecasted 4.9%. The national debt, already a point of concern, has grown due to heavy spending on public services and measures to mitigate the impacts of the pandemic and energy crisis. With rising interest rates, borrowing costs have surged from €29 billion in 2020 to over €50 billion this year, projected to reach €80 billion by 2027.

The French government aims to reduce the deficit to 3% of GDP by 2027, meeting the EU threshold, but economists and S&P see this target as unlikely. S&P forecasts the deficit-to-GDP ratio will stand at 3.5% in 2027, with general government debt rising to 112% of GDP from 109% last year. Macron's administration has been cutting spending, with targeted savings on climate policies and education subsidies to reduce the deficit by €10 billion this year and planning another €20 billion in cuts next year.