Market Update: Central Banks Are Starting To Cut Interest Rates

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the cliff-notes:

• The ECB cut its policy interest rate by 25 basis points, citing inflation dynamics and policy strength.
• This follows the Bank of Canada's 25-bps cut, marking a shift from tight to loose conditions amid slowing growth.
• In the US, the Fed faces different conditions, with stable growth and labor demand falling, making a rate cut less likely soon.

Last Thursday, the European Central Bank cut its policy interest rate by 25 basis points, or one-quarter of one percent. It is the largest central bank of the cycle that has made the move toward easier policy. In its statement, it cited the "dynamics" of underlying inflation, its updated inflation outlook, and the strength of policy transmission as reasons for the move:

This marks the second of two G7 countries that decided to cut their policy interest rate for the first time this cycle. The European Union is a member of the G7, despite not being a single country, for its important role in the world economy. The Bank of Canada cut its overnight lending rate by a 25-bps increment on Wednesday, the day before the European Central Bank cut.

Note: these are very tiny rate cuts. They are aimed at incrementally transitioning from tight to loose conditions as the pace of economic activity slows, but it is still growing.

These are not rate cuts in response to recession, but rather, in anticipation that the economy has inflected past peak growth and is on a decelerating trajectory. These cuts have minimal impact in and of themselves, and are moreso to ensure stability in financial plumbing, and to test how the market reacts to easing. Dipping your toe in the water to test the temperature, per se.

Central banks coordinate monetary policy moves to minimize capital flight and maintain global balance of payments as best they can when going from tight to loose and vice versa:

Wait a minute.

The ECB revised its inflation forecast higher, not lower, yet it still cut interest rates. You'd want to see the path for inflation reflecting lower before easing up the reigns on interest rates.

The path for inflation inflects higher, and deciding to begin cutting interest rates, is like noticing that the water in your pool isn't draining as quickly, so you turn the hose back on. A very baffling move:

Most Euro-Area countries still have inflation above the ECB's 2% yearly target, so Lagarde and Co. must be very confident that price inflation is headed back down to target if they're making a move to cut at a time like this:

Central banks, ECB included, tend to be very late to the party—they were too late to raise rates when inflation was rising, ultimately letting it rise to 11% at its peak. It is never early to the party, which is what makes it cutting rates before price inflation has clearly trended downward to 2% very concerning. It gets it wrong most of the time, the chances that it got it wrong this time are very high.

Cutting rates too early means risks for price inflation are tilted to the upside. However, in Europe, growth concerns are much higher. The labor market is loosening very quickly, and manufacturing activity is slowing faster than in the US. So, the ECB cutting rates now, for once, may also be very prescient. Time will tell:

When the Fed paused too early, price inflation stalled out above 3% and has been stuck here for almost a year. The ECB did the exact same thing. Here in the States, growth is much more stable and only decelerating in a few sectors, not economywide. As such, the Fed cutting interest rates now, even in a 25-bps increment like its G7 counterparts, would not be a good idea:

Slack in the labor market is going in the other direction in the US.

Labor demand was abundant and supply was scarce, with almost 2 openings for every unemployed worker. Now, there are only 1.2 openings for every worker. Once it dips below 1, we'll already be in recession. JOLTS job openings shed 291,000 in April, down to the lowest level since February 2021.

This is what the Fed cares about most, at this point. With price inflation stuck above 3% for a year, the last shoe to drop before it can move any lower will be the labor market. Labor demand is falling, coming into better balance with supply:

At the time of writing, the odds of a rate cut in the United States are at ~50% for September, with close to 100% odds of one 25-bps cut by November. Slower than our European compatriots and our neighbor to the north due to our much greater economic might, and thus the longer time it is taking to decelerate:

Final thought: the path of least resistance for asset prices is still higher.

Take it easy,

Joe Consorti

Theya is the world's simplest Bitcoin self-custody solution. With our modular multi-sig vaults, you decide how to hold your keys.

Whether you want all your keys offline, shared custody with trusted contacts, or robust mobile vaults across multiple iPhones, it's Your Keys, Your Bitcoin.

Download Theya on the App Store.