Global Interest Rate Cut Wave Begins

As more developed economies begin to lower interest rates, a new round of global interest rate cuts has been initiated. The global economy may enter a new upward cycle, which will help to further warm up China's exports, and the pressure on the renminbi will also be significantly alleviated in the future.

Following the interest rate cuts by the central banks of Switzerland, Sweden, and Canada, the European Central Bank (ECB) also announced a rate cut on June 6th, marking the first rate cut by the ECB in five years. Since then, more developed economies have started their rate-cutting cycles, with the market waiting for the Federal Reserve to join.

The ECB lowered its three main policy interest rates by 25 basis points each. After the rate cut, its deposit facility rate stands at 3.75%, the marginal lending rate at 4.50%, and the main refinancing rate at 4.25%. Regarding balance sheet reduction, the ECB plans to continue reinvestments under the Pandemic Emergency Purchase Programme (PEPP) in the first half of the year, and then reduce the PEPP by an average of 750 million euros per month in the second half of the year, until the reinvestments under PEPP are exited by the end of the year.

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The market is more concerned about the subsequent path of ECB's rate cuts, but the ECB stated, "We do not make any pre-commitment to any specific interest rate path." Currently, the market expects the ECB to cut rates twice in the second half of the year. The policy outlook of the Federal Reserve remains unclear, with strong non-farm employment data in May, coupled with persistently stubborn inflation, which will continue to make the Federal Reserve indecisive.

Although this round of global interest rate cuts may not be as smooth as in the past, the general direction of rate cuts is more certain. Under this backdrop, the renminbi's composite exchange rate is likely to enter an appreciation cycle, which will be beneficial to the autonomy of China's monetary policy operations and expand the operational space for China's monetary policy.

Why did the ECB cut rates before the Federal Reserve?

Since 2024, as global inflation has retreated and the economies of some major countries have slowed down, several developed economies have started their rate-cutting cycles. In March 2024, the Swiss National Bank cut rates by 25 basis points, becoming the first G10 country to do so. The Riksbank of Sweden cut rates for the first time by 25 basis points on May 8th, and the Bank of Canada also cut rates by 25 basis points as expected on June 5th, with the ECB starting its first rate cut in five years on June 6th. Expectations for a rate cut by the Bank of England are also heating up, and it is very likely to announce its first rate cut soon.

The policy adjustments of the ECB and the Federal Reserve are the most closely watched by the global market. Since the fourth quarter of 2023, market expectations for rate cuts by the Federal Reserve have been fluctuating, but they have not yet materialized, while the ECB has taken the lead in starting the rate-cutting cycle.

Historically, the Federal Reserve's policies have often been a benchmark for central banks around the world, with the Federal Reserve's rate-cutting cycles usually leading those of the ECB, and the short-term rate-cutting力度 being greater than that of the ECB. During the rate-cutting cycle from 2001 to 2003, the Federal Reserve began cutting rates in January 2001, while the ECB only followed in May of the same year. Moreover, the Federal Reserve quickly cut rates by 425 basis points in 2001, while the ECB only cut rates by 50 basis points during the same period. During the rate-cutting cycle from 2007 to 2008, the Federal Reserve first cut rates in September 2007, and in just over a year, it brought the benchmark interest rate to zero, while the ECB did not start cutting rates until November 2008.

Why did the ECB cut rates before the Federal Reserve this time? After the pandemic, there has been a certain divergence in the development of economies and inflation among the world's major economies. Europe's inflation has retreated more smoothly than that of the United States, which is the main reason why the ECB cut rates before the Federal Reserve this time.Haitong Securities believes that both the European Central Bank (ECB) and the Federal Reserve have adopted a 2% inflation target. However, since 2024, the progress of "disinflation" in the United States has stalled, while the decline in inflation in the Eurozone has been relatively smooth. Therefore, the ECB may have more confidence in "disinflation" than the Federal Reserve.

Although high inflation in Europe after the pandemic was once more severe than in the United States, this was largely due to the high energy prices caused by geopolitical conflicts and the supply-demand imbalance brought about by supply chain shortages. After the pandemic eased, the supply chain was restored, and coupled with the ECB's substantial interest rate hikes, commodity inflation fell rapidly.

The biggest difference in inflation between Europe and the United States mainly comes from the non-energy sector. Faced with high interest rates, the European economy has declined more, and the demand side has had a stronger effect on curbing inflation. The main contributor to U.S. inflation is housing, and under the influence of wage and housing market resilience, inflation is more stubborn. The Eurozone's inflation has a higher weight for goods, and the real estate market performs weaker than in the United States. Looking at the core CPI (CPI excluding food and energy), the Eurozone's peak is 5.7%, while the United States' peak is 6.6%. In May, the Eurozone's core CPI year-on-year had already dropped to 2.9%, while the U.S. core CPI remained high at 3.6%.

In terms of the economy, Europe's economic performance is weaker than that of the United States. To avoid the economy sliding into recession, the ECB also had to relax its policies earlier. In the last four quarters, the average quarterly seasonally adjusted growth rate of Eurozone GDP was only 0.05%, with negative quarter-on-quarter growth in the third and fourth quarters of 2023. In comparison, the U.S. economy is much more resilient, with an average quarterly GDP growth rate of about 0.7% from the second quarter of 2023 to the first quarter of 2024.

Haitong Securities points out that since 2023, the Eurozone's economic performance has been weaker than that of the United States, partly due to the relatively weaker fiscal policy stimulus in the Eurozone. In 2023, U.S. fiscal policy continued to expand in a counter-cyclical manner while maintaining a low unemployment rate, with the deficit rate rising again, remaining around 7% in 2023, and even exceeding 8% in the second quarter. In contrast, the Eurozone's deficit rate was less than 4% in 2023, with a relatively weaker economic stimulus effect compared to the United States.

The path of interest rate cuts is more important.

Faced with the ECB's first interest rate cut, the market's reaction was relatively lukewarm, and there was no significant disturbance in the financial markets. On the one hand, the expectation of a rate cut had been released months ago, and the market had already anticipated the outcome of the rate cut in advance; on the other hand, compared to a 25BP rate cut, the market is more concerned about how quickly subsequent rate cuts will occur and the overall magnitude of the rate cuts.

The European Central Bank did not make any commitment to the future path of interest rate cuts. The ECB meeting statement stated, "No pre-commitment to any specific interest rate path," and also claimed, "As long as necessary, interest rates will be maintained at a sufficiently restrictive level."

ECB President Christine Lagarde also emphasized that interest rates need to be kept restrictive for a sufficiently long time to ensure lasting price stability. She said, "Even if we don't press as hard as before, we still need to keep our foot on the brake for a while."

In fact, it is not surprising that the ECB has made such a statement. Historically, the ECB's actions after the first interest rate cut have always been relatively "hesitant." For example, during the rate cuts in 2001, the ECB cut rates for the first time in May, but the second rate cut was delayed until December; on the eve of the 2008 global financial crisis, the global economy was already fraught with crises, but the ECB was still raising interest rates until it initiated the first rate cut in November 2008.What impact will the ECB's interest rate cut have on the economy and markets? Haitong Securities believes that the current interest rate level in the eurozone is still relatively high, and even a 25BP rate cut may still have a certain suppressive effect on demand such as consumption and investment. Therefore, the short-term economic stimulus from this rate cut may be relatively limited. Looking at the impact on asset prices, the euro remained relatively strong after the rate cut. The ECB's "hawkish" stance on the rate cut introduces significant uncertainty about the magnitude and pace of future rate cuts, which to some extent constrains the market's imagination about future ECB rate cuts, and thus does not exert too much depreciation pressure on the euro.

China Galaxy Securities believes that the ECB's rate cut in this round is not aimed at significantly stimulating the economy, but rather taking into account the easing of inflationary pressures, the magnitude and intensity of future rate cuts cannot be compared with the crisis period. In 2024, European fiscal policy is also likely to contract, which means that the upward momentum of the eurozone economy will not be too strong. The improvement in demand in the eurozone is likely to be moderate, and the slope of inventory replenishment will not be too steep.

Is a Fed rate cut far behind?

The situation in the United States is much more complex than in Europe. Since the beginning of the year, the decline in U.S. inflation has tended to stagnate, while economic activity and employment have not significantly slowed down, leaving the Fed indecisive.

In May, the U.S. added 272,000 non-farm jobs, significantly higher than market expectations, with average hourly wages growing by 4.1% year-on-year, and the wage growth momentum has not slowed down. The market began to doubt the "authenticity" of the non-farm employment data, and the influx of a large number of immigrants in recent years may have made the employment data look "much better."

Anyway, once analysts start to get entangled in too many details of the data, it also indicates that the market's views on the fundamentals are quite divided and have not formed a more obvious trend change. The expectations reflected in the federal funds futures market are that the Fed may only consider rate cuts in the fourth quarter.

What is even more confusing is that the Fed's monetary policy seems to be less effective. In the past, the Fed could effectively regulate the economy and inflation by adjusting policy interest rates, but this time, facing the highest interest rate level in more than 20 years, the economy and inflation have not declined as expected.

Koichi Hamada, Chief Economist at Nomura Capital Market Research Institute, pointed out that the issues left over from the era of quantitative easing are weakening the tightening effects of the Fed, making it difficult for the Fed to combat inflation. The quantitative easing policy implemented after the 2008 financial crisis led to banks holding a large amount of excess reserves, which has rendered traditional tools ineffective. Despite consecutive substantial rate hikes, the financial environment remains relatively loose.

The Renminbi is likely to enter an appreciation cycle.

Although the future path of rate cuts by the ECB and the Fed may still have significant uncertainties, the prelude to global rate cuts has already begun. In the future, developed economies will gradually bid farewell to the high interest rate environment caused by high inflation, which will have a lasting impact on the global economy and financial markets in a broad direction.Over the past six months, global markets have actually been anticipating this interest rate cut expectation in advance, and the easing of monetary policy is always welcome for the stock market. As of June 10th, major global stock indices have all achieved increases, with Japanese and European and American stock markets showing strong performance. Among them, the Nikkei Index, the NASDAQ Index, the S&P 500 Index, and the German DAX Index have all increased by more than 10% year-to-date.

In terms of exchange rates, the market may pay more attention to the obvious exchange rate of the Chinese yuan against the US dollar, but the Chinese yuan exchange rate index may better reflect the fundamentals. The CFETS Chinese Yuan Exchange Rate Index refers to the CFETS currency basket, which specifically includes various foreign exchange trading currencies against the Chinese yuan listed on the China Foreign Exchange Trade Center. The sample currency weights are calculated using the trade weight method considering the factors of transit trade.

Since 2020, the CFETS Chinese Yuan Exchange Rate Index has roughly experienced a complete cycle, basically reflecting the changes in the global interest rate cycle. From 2020 to 2022, after the pandemic, overseas central banks have significantly reduced interest rates and introduced quantitative easing policies. Due to the lack of strong stimulus in domestic macro policies, the Chinese yuan exchange rate index appreciated significantly during this period, rising from 91.4 at the end of July 2020 to 106.8 in March 2022. From March 2022 to July 2023, to combat global high inflation, overseas central banks have adopted significant tightening policies, with benchmark interest rates rising rapidly. The Chinese yuan exchange rate index depreciated during this period, falling from 106.8 to around 96.

The second half of 2023 is an important turning point. The Federal Reserve and the European Central Bank have ended their last interest rate hike and have entered the interest rate cut expectation phase. Coupled with the continuous recovery of China's economic strength, the Chinese yuan exchange rate has also gradually strengthened. If one only observes the changes in the Chinese yuan against the US dollar, it is not easy to see this major trend of change. Since July 2023, the Chinese yuan exchange rate index has risen from 96 to around 100.

Before the resumption of the Federal Reserve's interest rate cut transaction, the Chinese yuan exchange rate may show a trend of "depreciation against the US dollar and appreciation against a basket of currencies." After the resumption of the Federal Reserve's interest rate cut transaction, the pressure on the Chinese yuan's bilateral exchange rate against the US dollar will be reduced.

As the global interest rate cut curtain is drawn, the pressure of Chinese yuan depreciation has been alleviated, which will be beneficial to the autonomy of China's monetary policy operations and expand the operating space for China's monetary policy.