Will the ECB Cut Rates Before the Fed? Exploring the Impact on Investment Strategies

Given European Central Bank (ECB) monetary policy discussions to lower interest rates after recent economic reports—Eurostat estimates for stable Eurozone annual inflation of 2.4% and Eurozone/EU first-quarter GDP growth of 0.3%—we explored the impact on several investment strategies.

Using a stress test report in Portfolio Analysis in the FactSet Workstation, we defined scenarios on interest-rate reductions, related economic indicators, and relevant geopolitical aspects.

Scenarios Details

In our scenario analysis, the base assumption is the ECB lowering the euro deposit rate by 25, 50, and 75 basis points (bps). That implies a phased monetary policy process on rates cut instead of a one-time intervention.

To this basis scenario we add assumptions for depreciation of the euro relative to US dollar, which is among the possible consequences under discussion if the ECB cuts rates before the US Federal Reserve reduces the federal funds rate. Based on International Monetary Fund (IMF) analysis on the topic, a 50-bps change in the spread between the rates in the US and Europe would lead to a minor 0.1% - 0.2% shift in the exchange rate. For a more conservative analysis, we applied a shock of 0.5% depreciation of the euro against the US dollar.

We have also factored in the impact of geopolitical tensions, which for this analysis adds stress to monetary policy, the economy, and financial markets. The ECB’s recent risk analysis includes the Middle East conflict, US-China tensions over Taiwan, and the Russian invasion of Ukraine as raising concerns about geopolitical stability.

Allowing for a scenario where geopolitical tensions increase after the deposit rates have already been cut, we explore four possible consequences that are suggested in ECB report:

• Crude oil price rise 10%

• EURO STOXX 50 down 1%

• VSTOXX 50 increases around 1.5 index points

• EUR Corporate spread increases 3%

Deposit Rate

The shocks in the analysis below are applied on the EURIBOR one-month rate, which as we confirmed in the below chart closely follows the European deposit rate (per ECB) as unsurprisingly based on the strong economic relationship between them. The reason to reflect the changes with the interbank reference interest rate is that its daily non-zero return allows for an accurate estimate of conditional correlation and returns of risk model factors (e.g., other interest rates, equity sector and region factors, exchange rates, etc.).

On the contrary, the deposit rate the ECB sets for the borrowing and lending transactions between the central bank and commercial banks would have a zero return most of the time (apart from days when the ECB changes it), which poses a challenge to compute a reliable correlation. The risk model’s conditional returns are required in the stress test analysis calculation. The reason is to propagate the impact from the shock factor to other risk factors in the model—and thus to all assets in the investment portfolio.

Investment Strategies Analysis

Given our focus on Europe debt and equity markets, we analyzed the impact of scenarios (as defined in previous section) to a few investment strategies represented by broad investable indices. For contrast, we have added the US broad equity and corporate bond markets.

Analysis of only interest rate reductions

Lower deposit rates would have positive impact on the equity market as investors would pivot from interest-bearing assets to the higher return potential of stocks. And more investment in equity markets would help raise stock prices.

Some sectors are less responsive to rate changes, such as Consumer Staples and Utilities where business is less dependent on rate levels and demand is more inelastic in nature. Conversely, the Real Estate and Consumer Discretionary sectors would benefit more in a lower interest rate environment as the cost of financing purchases would also be lower.

There is an inverse relationship between interest rates and fixed-rate bonds, while floating-rate notes tend to preserve their value. Lower interest rate scenarios thus manifest positive debt market returns for investment grade, high yield, corporate, and government bonds.

The impact from lower interest rates intensifies with the magnitude of interest rate reduction

As lower interest rates may divert capital to higher interest rate locations, we see the positive impact will be higher for US markets compared to EU markets.

Depreciation of EUR analysis added

A reduction in the euro FX rate relative to the US dollar is expected to make European assets less attractive compared to other regions with similar credit ratings. Thus, in the following scenario table, it is not surprising to see the positive returns of both US investment strategies compared to all of the European investment strategies, which report losses. The magnitude of the scenario and its reported output is very small, as the depreciation of the currency related to a reduction in interest rates is also expected to be minor.

We have also added the combined effect of a Europe deposit interest rate cut and depreciation of the euro relative to the US dollar by 0.5%. There is no major impact from adding the EUR depreciation with returns only slightly lower compared to the respective scenarios, under which only interest rates are reduced and all investment strategies benefit.

If geopolitical tensions increase after the ECB lowers deposit rates

Based on ECB analysis of impacts from geopolitical risk and financial instability, we explored several possible implications: an increase in crude oil prices, a downturn for equity markets, a spike in equity market volatility, and a rise in credit spreads.

As a first step we explore the impact of each of these negative scenarios of equity and bond indices, as well as their total effect in one combined scenario: geopolitical risk increase.

An oil price increase has negative impact on bond markets in both regions—higher oil prices imply higher inflation, which leads to higher yields and lower bond prices. Among equity markets, there is a small positive impact from an increase in oil prices, based on the slightly positive correlation between oil prices and equities in the last 10-plus years.

Scenarios with EUROSTOXX index drop and volatility spike both have negative impacts on equity markets in both regions, as developed markets exhibit high correlation. The European equity market is, as expected, more affected by the shocks. European bond indices also report a small negative return under these scenarios.

The scenario with the EUR corporate bond spread widening leads to negative returns on the euro high yield bond and equity indices. That’s because it is related to increased risk and thus impacts riskier assets. In this environment, investors would turn to less risky assets, so US bonds and European government and investment grade bond indices would generate positive returns.

A geopolitical risk increase scenario combines all of the above listed shocks. The report shows this scenario in total has negative implication on all investment strategies, with magnitude decreasing for less risky assets (government and investment grade bonds or US region bonds). It is not surprising that in an environment of higher market uncertainty and lower consumer confidence, risk-averse investment strategies are more attractive and perform relatively better.

For the next scenario, we analyzed the combined effect of all previous scenarios on the indices. The following table illustrates the adverse effect of the combined shock across all indices in both the US and Europe regions.

The Europe equity market appears to suffer most under all three combined scenarios, as geopolitical tension poses negative pressure on equity market returns and stocks are no longer benefiting from the lower interest rates. The prevailing effect is from EUROSTOXX drop by 1% shock, as the correlation of EUROSTOXX with any broad European equity index is close to 1 and blurs the rest of the stressed factors' impact.

Europe investment grade bonds and high-yield bonds report negative return only under the smallest rate cut of 25 bps in our combined scenario. With larger rate cuts for deposits, the positive impact to bond prices seems to prevail over the negative impact from higher geopolitical risks, ultimately resulting in positive returns for these investment strategies.

Under all rate-cut scenarios, the Euro Government Bond Index appears more resilient to the geopolitical shocks and benefits from the positive effect of the lower deposit rate. As the least risky asset type in times of crisis, government bonds would attract investors from stocks and credit bonds.

Not surprisingly, US equity and bond indices would outperform respective European indices. The reason: Higher interest rates and a favorable exchange rate would attract more investors to US investments when there are EUR rate cuts and EUR depreciation. Importantly, all geopolitical shocks have been applied directly to European-only factors for the purpose of our analysis, therefore causing larger impact on European-based assets.

Conclusion

Scenario analysis shows the positive consequences of loose monetary policy across all investment strategies. In addition, we explored and showed there would be a very small effect from EUR depreciation as a direct consequence of Europe cutting interest rates before the US.

However, in an environment of heightened geopolitical tensions, some of the positive effects of a deposit rate reduction may be wiped out or at least smoothed by financial markets’ responses.

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