Will the ECB really cut interest rates in 2024?

Christine Lagarde, the Chair of the European Central Bank (ECB), had until now refrained from discussing rate cuts due to prevailing high inflation, saying that it could be risky to cut interest rates too early and that the central bank initiatives to bring back inflation to 2% were far from done.

However, some recent speeches by ECB officials are signaling a potential rate cut in the upcoming year, including an interview with Lagarde from last week.

The specific timing of any rate cuts will be contingent on the monthly data and economic indicators, as highlighted by Governing Council member Francois Villeroy de Galhau.

While ECB’s Lagarde hinted at the possibility of rate cuts in the summer during the Davos meeting held on January 14-19 2024, she also emphasized the ECB’s commitment to a data-centric approach, even though she confirmed the possibility of European interest rates having reached their peak.

According to a Reuters poll, the median expectation suggests a forecast of 100 basis points in cuts this year, bringing the ECB’s deposit rate to 3.00% by the end of 2024.

But can market participants truly anticipate interest rate cuts in 2024? What do polls indicate about the timing of these potential rate cuts?

How do European inflation, growth, and employment figures contribute to the analysis? In light of these considerations, how should investors prepare for various scenarios?

Let’s delve deeper into these questions.

While inflationary pressures appear to be easing, other indicators are not meeting the anticipated levels set by the ECB committee

After surpassing 10% in the summer of 2022, the Euro Area’s annual inflation rate for December rose from November to 2.9%, up from 2.4%, as reported by Eurostat. This marks the lowest level in over two years.

The European Central Bank (ECB) anticipates inflation to reach 2.7% this year and 2.1% next year.

However, ECB President Christine Lagarde cautions against premature celebrations, particularly concerning the inflation-wage spiral that might still be in play.

Lagarde points out that employees experienced a loss of purchasing power in 2021 and 2022, leading to negotiations for increased salaries, which can impact consumption and, consequently, inflation.

In April or May, Lagarde stated that the ECB is anticipated to gain a clearer understanding of salary trends, enabling them to evaluate the possibility of initiating discussions about rate cuts.

In the meantime, she emphasized that excessive optimism and heightened market expectations regarding rate cuts could impede the ECB’s efforts to combat inflation.

Additionally, there remains a level of uncertainty concerning the state of global and European economic growth, with potential factors like geopolitical events (such as major elections worldwide, commodity price fluctuations, the conflicts in Ukraine, Israel, and the Red Sea, supply chain disruptions, etc.) that could materialize and impact the prospects of inflation and growth.

Rate cuts vs higher for longer – How to take advantage of both scenarios

The investment opportunities in the event of a rate cut can vary depending on the broader context.

A rate cut driven by a strong economy and a return of inflation towards the 2% target is preferable compared to cutting interest rates due to rising recession risks that could threaten the overall economy. The market dynamics and investment strategies will also vary depending on the scenario.

Here are 4 investment opportunities to consider in case of rate cuts.

1. Stocks of home improvement retailers or companies linked to real estate become an appealing choice when interest rates are decreasing, along with consumer discretionary spending.
2. When expecting rate cuts, exploring investment possibilities in bonds at the end of a tightening cycle could be interesting. This is due to the likelihood that newly issued bonds will have lower coupons following the rate cuts, consequently causing an upswing in the prices of older bonds issued when interest rates were higher. Additionally, the bonds acquired when interest rates were higher are now providing a more favorable coupon than current bonds with lower interest rates ;
3. Choosing to invest in growth stocks heavily reliant on borrowed funds can be a good option during rate cuts. The lower borrowing costs for funding their growth may boost profitability, leading to higher stock prices. Considering the significant surge seen in specific growth stocks, especially in the tech sector, in 2023, focusing on growth stocks in promising sectors like health or cybersecurity could be worthwhile ;
4. Even in the context of rate cuts, an interest rate differential may persist between two nations or currencies, and forex traders can use currency carry trade strategies. Where the currency being borrowed features a lower interest rate than the one being invested in, traders earn the interest rate spread. The regulated CFD broker ActivTrades about factors to watch out for when trading currency pairs in a previous article about the EUR/USD

Should the ECB decide to keep interest rates at their current levels, instead of following the United States in cutting them (assuming the U.S. opts for rate cuts), traders and investors can choose between various investment opportunities.

Here are 3 investment opportunities to consider in case of high rates for longer.

1. In periods of high(er) interest rates, financial stocks often increase in value thanks to increased profitability. Additionally, financial institutions also profit from stronger balance sheets and better earnings, making them more attractive to investors ;
2. In a high-interest-rate environment, bonds can provide attractive fixed-income yields, relatively high coupon payments, and a relatively low level of risk, making them a conservative investment choice, especially for investors seeking stable income streams and aiming for capital preservation ;
3. During a prolonged period of elevated interest rates, concerns about future economic growth may emerge, prompting investors to seek refuge in safe-haven assets like gold. Additionally, the Federal Reserve’s inclination toward interest rate cuts could contribute to a weakening U.S. Dollar, traditionally supporting Gold prices. Moreover, the significant geopolitical risks in 2024, marked by elections in more than 50 countries, may also lend support to Gold prices.