ECB chief economist warns investors banking on rate cuts
The chance of a rate cut boosted the stock market this year. But Philip Lane, European Central Bank (ECB) chief economist, warns investors not to count their chickens before they hatch.
“Where I do think the market should ask itself questions is about the timing or the speed of reversal of restrictive policy,” Lane told CNBC on Tuesday.
The ECB economist added that Eurozone interest rates won’t come down to the 2% range until at least 2025:
“We will not be back towards 2% for a couple of years. We will make good progress even this year, especially in the later part of the year, but it’s not going to collapse to 2% within a few months.”
The ECB Governing Council decided to raise three key central bank rates by 0.25% in June. ECB president Christine Lagarde said the bank has more “ground to cover,” and called a July rate hike “very likely.”
Stocks rally on rate hike pause
In its June meeting—and after a 15-month streak—the Fed held over on hiking rates further.
In anticipation of the impending pause, the S&P 500 rallied over 15% this year. After the announcement, the benchmark soared another 1.8% in just two weeks.
Stocks could have rallied higher if, instead of a pause, the Federal Open Market Committee (FOMC) had announced rate cuts. In fact, as the economy’s recovery gathered, many analysts expected rate cuts.
As early as March of this year, analysts at the Tokyo-based Nomura Group said they expected the Fed to cut interest rates. In late-May, Plurimi Group chief investment officer Patrick Armstrong said:
“If Powell cuts, he probably cuts a lot more than the market’s pricing, but I think there is above [a] 50% chance where he just sits on his hands, we get through year-end.”
💡 Here’s how it works: The effect of interest rates on stocks is twofold.
The most direct and obvious effect is that rising interest rates boost borrowing costs for companies and consumers. In turn, corporate expenses plump up and consumers limit their spending.
The second and lesser-known effect is on a technical valuation level.
At the most basic level, a stock is worth the present value of all the money it is expected to make in its lifetime. The greater the anticipated earnings, the more investors are willing to pay for a share in that stock.
The catch is that the company will make some of that money in the future; maybe 10-20 years down the road. Analysts, therefore, discount those earnings at a rate that largely depends on interest rates.
So when the Fed raises rates, the present value of the company’s future earnings drops, and so does its valuation.
The Fed and ECB project more rate hikes
Even with a bullish first half of 2023, stocks are not yet out of the woods.
Although the Fed has paused, there are no indications of a potential reversal in policy. Fed chief Powell explicitly framed it as a way to “measure the temperature.”
In fact, according to the most recent dot-plot, the Fed’s members project another 0.5% hike by year’s end.
The culprit is sticky core inflation in both the U.S. and Europe. Headline inflation for Eurozone hit 5.5% in June, with core inflation remaining stubbornly high at 5.4%.
Meanwhile, U.K. inflation persisted at a soaring rate of 8.7% through May.
The strength of employment numbers and persistent inflation will likely make another rate increase appropriate. So, with scant expectations of a rate cut, a further stock market rally may be premature.