While the US Federal Reserve is expected to keep policy rates unchanged this week, the consensus is for the European Central Bank to lower the key deposit rate by 25 basis points to 2.75%. Is this the start of diverging trajectories for policy rates between the US and Europe? Much will depend on whether President Trump’s bite is worse than his bark on tariffs and trade policy.
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President Trump began his second presidential term with a series of high-profile actions. Among other things, he pardoned those involved in the Capitol riots four years ago, attempted to end birth right citizenship and made it much harder to legally enter the US.
The new administration is to begin detailed investigations into other countries’ trade practices, potentially setting the stage for a major trade conflict. On energy he has withdrawn the US from the Paris climate agreement and is trying to promote US oil and gas production.
President Trump also threatened to put in place substantial tariffs on several countries – including China, Mexico and Canada – starting in February. For now, there is hope that the talk of tariffs is more of a bargaining tactic than firm policy, but this is far from certain.
To close his first week in office President Trump called for looser monetary policy from the Federal Reserve (the Fed), saying that he knew rates “much better” than the Fed and would like to see them fall “a lot”.
European Union under pressure
During a virtual roundtable at Davos, President Trump made his first remarks about the European Union (EU) since his inauguration – they were far from constructive. Amongst other things, he blamed the EU for creating a significant trade surplus with the US.
Europe and in particular Germany have much to fear from US tariffs. Nearly 10% (9.9%) of German exports went to the US in 2023, the highest level in 20 years. At the same time, Germany imported EUR 94.7 billion in goods from the US last year, resulting in a record trade surplus of EUR 63.3 billion, the highest level since 2017 in comparison with other destination countries for German goods.
ECB to further loosen monetary policy
The European Central Bank is universally expected to deliver a 25bp cut when it meets on 30 January. The last meeting in December delivered a clear message that more rate cuts are the base case from here. According to data from Bloomberg on 27 January, markets price the ECB lowering its deposit rate from 3% currently to 2% by the summer.
High uncertainty about economic (e.g. US tariffs) and political developments (elections in Germany, political stasis in France) points to continued gradualism in the ECB’s approach to rate cuts. January has offered little new information to base any change in communication on, so continuity is likely. The ECB’s may retain a somewhat restrictive stance, suggesting more rate cuts are on the way, but stressing data dependency and a meeting-by-meeting approach.
Direction of travel is less obvious for the Fed
Fed Chair Powell has the benefit of taking some time to observe events under President Trump’s new administration to see exactly what happens. The overwhelming consensus is for monetary policy to remain on hold at the 29 January FOMC meeting, with the statement continuing to condition “the extent and timing of additional adjustments” to policy on data, the US economic outlook and risks. While Powell will probably keep his options somewhat open for March, there may be an indication that the most likely path for the next few FOMC meetings is a continued hold.
The Fed’s messaging from the December meeting still looks appropriate: Powell stated then that “as long as the economy and the labour market are solid, we can be cautious as we consider further cuts.” The economy and the labour market have since been more than “solid” – closer to “strong” – so a cautious approach seems warranted.
On tariff and immigration policies, Powell emphasised the need to “not rush and make a very careful assessment” of these “only when we’ve actually seen what the policies are and how they’re implemented.”
While markets continue to price two further rate cuts (each of 25bps) this year, there is much discussion among investors about the direction of US monetary policy. Apart from the uncertainty about the detail of the new administration’s policy measures, there is an increasingly widespread belief that the neutral interest rate has risen sharply since 2020. If the nominal neutral rate is as high as 3.75%, it suggests policy is merely slightly restrictive with only a few cuts required to reach a neutral stance. Fed policymakers recorded a much lower estimate in December, but the frequency with which they express uncertainty about the neutral rate suggests they are taking this estimate with a large pinch of salt.
Tech stocks rebound after DeepSeek spooks markets
Tech stocks rebounded on 28 January, as markets steadied following a rout on 27 January sparked by Chinese start-up DeepSeek’s advances in artificial intelligence. Shares in the largest US chipmaker rose 5.2% in pre-market trading following a historic 17% fall the previous day. The drop in valuation, which helped drag down the tech-focused Nasdaq Composite index by 3.1% on 27 January, came as DeepSeek’s new model created doubts about valuations across the tech sector and the continued dominance of the US in AI. This event has been timely in demonstrating that even technology stocks need to have a risk premium. The sell-off has also been a healthy reminder that neither valuations nor technological development advance in a straight line.
Disclaimer
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
