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The European Central Bank (ECB) has become the first of the 'big three' to cut interest rates since the start of the Covid pandemic, its deposit rate cut by 0.25% to 3.75%. We discuss what this means for investors and how Nutmeg portfolios are investing in Europe. 

Why has the European Central Bank made its move now? 

Arguably the most important influence on central banks when determining base interest rates is inflation, which has fallen significantly since it peaked at 10.6% in October 2022. The latest figure, year-on-year to May, had eurozone inflation coming in at 2.6%. This was actually slightly higher than the April figure of 2.4%, though the overarching trend is for falling inflation over the past two years. 

However, that's not the only influence behind the ECB's thinking, as it has also been keeping a close eye on economic growth in the region. Growth in the eurozone has been weak for some time - in the first quarter of this year it was 0.3%, having fallen by 0.1% in the fourth quarter of 2023.

A key factor behind the ECB's decision is that lower interest rates could bring new borrowers into the market, stimulating the economy through spending and investment. However, this can be a balancing act, as policymakers do not want to bring about more inflation. 

At the start of 2024, it was the US Federal Reserve (Fed) that was expected to lead the rate-cutting cycle, but this has been stalled by better than expected economic data and 'sticky' inflation readings that raised questions about how far inflation can keep falling. Indeed, inflation has trended higher so far in 2024 - the US Consumer Prices Index (CPI) was 3.4% in the 12 months to April, compared to 3.1% in January. 

While the other members of the 'big three' - the Fed and the Bank of England - have held off, the ECB had signalled this cut in public speeches and interviews. For example, in a recent interview with Irish broadcaster RTÉ, the Bank's president, Christine Lagarde, said there was a "strong likelihood" of a cut "if the data that we receive reinforces the confidence level that we have". As such, markets had been anticipating this and are expecting further cuts to come. 

Why is this rate cut such a significant event? 

This marks the first time the ECB has cut eurozone borrowing costs since September 2019, before the Covid pandemic brought much of the global economy to a halt. The aforementioned inflation surge that started in 2021, as the world started to open up after lockdowns, has hurt most major economies. This prompted central banks to raise interest rates to bring headline inflation figures down

While the ECB is not the first central bank to start to reverse these hikes - we've already seen cuts in Sweden, Switzerland and Canada - it's the first of the 'big three' to act.

While ongoing upward price pressures make nothing certain, the ECB's move could be seen as a sign of the beginning of a normalising of the global economy with more manageable inflation to come. 

When will the Bank of England and the Federal Reserve cut interest rates?

The truth is, we still don't know if they will act this year, or in 2025. Again, this depends on an assessment of inflation.

In the UK, the Office for National Statistics announced a drop in CPI from 3.2% to 2.3% in the year to April 2024, sitting now just above the Bank of England’s 2% target. This is a significant fall from its peak of 11.1% in October 2022, however Bank governor, Andrew Bailey, said he wants to "see more evidence" that prices have slowed before acting.

The Bank's Monetary Policy Committee (MPC) is due to meet again on 20th June to discuss the base rate, which is currently at 5.25%. There is some suggestion that the MPC could act then, though markets are not expecting any firm action until August at the earliest, when the MPC will have a clearer picture on inflation. 

Markets are less certain on the direction of travel in the US, where the Federal Open Market Committee (FOMC) hiked rates 11 times between March 2022 and July 2023 to the current target range of 5.25% to 5.5%.

There were suggestions of three quarter-point cuts by the end of this year, however expectations have changed with some commentators not anticipating the first cut until 2025. The US CPI rose by 3.4% in the 12 months to April as higher rents and petrol costs weighed on the cost of living. Like in the UK, the Fed has an annual 2% target rate for inflation, and still has work to do to bring price increases down. 

What do lower rates mean for markets? 

Central bank base rates influence interest rates in the retail banking market: for businesses, homeowners and consumers. Lowering interest rates stimulates economic activity by encouraging borrowing and making investing relatively more attractive than saving. This easing of monetary policy is generally good news for equity markets. 

How is Nutmeg investing in Europe in light of this?

Our investment team will continue to monitor Europe, and the market reaction to potential further interest rate cuts as they happen. In Nutmeg portfolios, we have a preference for European industrial stocks, especially given a path of recovery that we are seeing in the global trade cycle. 

You can learn more about our European positioning in our recent View from the investment desk update

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.