Central bank signals this might be enough to combat inflation, but doesn’t rule out further increases
4 min
FRANKFURT—The European Central Bank raised interest rates by a quarter percentage point to a record high but signalled that eurozone borrowing costs may have peaked, sending the euro tumbling.
In a split decision, ECB officials raised the bank’s deposit rate to 4%, the 10th increase in a row and a vertiginous rise from below zero last year.
At a news conference, ECB President Christine Lagarde signalled that Thursday’s rate increase might be the last, although she didn’t rule out further hikes if economic data disappoint.
ECB officials judge that rates “have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution” to reducing inflation to their 2% target, Lagarde said, repeating language used in the bank’s policy statement.
The comment prompted investors to downgrade their expectations for future ECB rates, sending the euro down by almost a cent against the dollar to below $1.07, its lowest level since March. Bond yields slid, with yields on the benchmark 10-year government bonds of Germany, France and Italy down between 0.05 and 0.10 percentage point. European stocks rallied, with the benchmark Stoxx Europe 600 index rising more than 1%.
The eurozone still has lower interest rates than the U.S., as well as higher inflation and a struggling economy that contrasts with relatively healthy economic growth in the U.S.—all factors that are weighing on the euro.
“In all likelihood the ECB is done,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management in Geneva.
Major central banks including the Federal Reserve are signalling a possible halt to a historic series of interest-rate increases over the past 18 months aimed at tackling a surge in inflation unseen since the 1970s.
Ending rate increases would favour borrowers amid uncertainty in the global economy, declining international trade and faltering industrial output. However, signalling a peak in interest rates now risks letting excessive inflation on both sides of the Atlantic become entrenched. Some central banks, including those of Australia and Canada, signalled a pause in recent months, only to start raising rates again.
Recent market movements suggest investors are now betting that rates will peak and even start falling as early as next spring as inflation and economic growth both come down.
They expect the ECB to hold interest rates at about 4% through next summer before starting to cut them, according to data from Refinitiv. They think the Fed will hold rates steady in a range between 5.25% and 5.5% at its meeting next week, and to start cutting rates early next year. The Bank of England is expected to increase interest rates at least once more this year before cutting them later next year.
Investors had been unusually divided before Thursday’s decision over whether the ECB would pause already or unveil one last rate increase. That disagreement reflects uncertainty over how much a slowdown in eurozone growth, together with the ECB’s past rate increases, will cool the region’s inflation rate, which stood at 5.3% in August, unchanged from a month earlier.
Lagarde said some of the central bank’s governors would have preferred to hold rates steady at this month’s meeting. However, a “solid majority” of them agreed on the decision to take rates higher, she said.
New economic forecasts published by the ECB Thursday suggested that eurozone growth will slow significantly more than previously expected this year and next, while inflation will remain markedly above the ECB’s target of 2% through next year. The bank raised its forecast for inflation next year from 3% to 3.2%, mainly to reflect “a higher path for energy prices.”
Asked about the prospect of rate cuts, Lagarde replied that “is not even a word we have pronounced.”
“The longer they can keep interest rates at elevated levels, the more insurance they buy against a downturn down the road,” said Robert Dishner, a senior portfolio manager at Neuberger Berman. “If they end up cutting too soon, they risk reigniting inflation.”
Central banks in Europe face a particularly daunting challenge because while recent interest rate rises have weighed heavily on lending and probably lowered economic growth, they have yet to show a marked effect on underlying inflation. This contrasts with the U.S., where the Fed has taken interest rates higher than the ECB and underlying inflation has fallen significantly while the nation’s growth remains robust. Underlying inflation in August was 5.3% in the eurozone and 4.3% in the U.S.
Recent data and business surveys signal a darkening economic outlook for Europe amid weak growth in China and a decline in global manufacturing. The eurozone economy has largely stagnated since late last year, and industrial production declined in July, dragged down by weakness in Germany, the region’s largest economy.
Lagarde warned that Europe is currently going through a phase of very sluggish growth and suggested that the ECB’s rate hikes are filtering through to the economy. “We are beginning to see weakness in the volume of hires particularly in the services sector that is related to manufacturing,” she said.
Meanwhile, a recent increase in oil prices is pushing inflation in the wrong direction. The euro has slumped against the dollar in recent weeks, to around $1.07 from $1.12 in July, as the eurozone’s economic prospects have soured. That increases the cost of imported goods, making the ECB’s job harder.
Matthew Ryan, head of market strategy at financial-services firm Ebury, said the ECB would likely start cutting rates later, and possibly at a more gradual pace, than the Fed, which should support the euro.
Some of the economic weakening is as intended. The ECB expects its rate increases to slow the region’s economy by weighing on asset prices and demand for loans. However, it isn’t clear if inflation is starting to fall because of the ECB’s actions or because of other factors, such as the fact natural-gas prices are dramatically lower compared with last year, when Russia throttled Europe’s gas supplies. This makes it hard to predict if the region’s economic slowdown will push inflation all the way down to 2%.
Market confidence in the ECB’s ability to achieve its objectives is gradually eroding, with the closely watched five-year, five-year inflation swap—a gauge of expected inflation over a 10-year horizon—standing at 2.6%, according to Franck Dixmier, global chief investment officer for fixed income at Allianz Global Investors.
High current and expected future inflation could mean that investors are underestimating the potential for further ECB rate increases, Dixmier said.
Copyright 2020, Dow Jones & Company, Inc. All Rights Reserved Worldwide. LEARN MORE
What a quarter-million dollars gets you in the western capital.
Alexandre de Betak and his wife are focusing on their most personal project yet.
4 min
U.S. investors’ enthusiasm over Japanese stocks at this time last year turned out to be misplaced, but the market is again on the list of potential ways to diversify. Corporate shake-ups, hints of inflation after years of declining prices, and a trade battle could work in its favor.
Japanese stocks started 2024 off strong, but an unexpected interest-rate increase in August by the Bank of Japan triggered a sharp decline that the market has spent the rest of the year clawing back. Weakness in the yen has cut into returns in dollar terms. The iShares MSCI Japan ETF , which isn’t hedged, barely returned 7% last year, compared with 30% for the WisdomTree Japan Hedged Equity Fund .
The market is relatively cheap, trading at 15 times forward earnings, about where it was a decade ago, and events on the horizon could give it a boost. Masakazu Takeda, who runs the Hennessy Japan fund, expects earnings growth of mid-single digits—2% after inflation and an additional 2% to 3% as companies return more to shareholders through dividends and buybacks.
“We can easily get 10% plus returns if there’s no exogenous risks,” Takeda told Barron’s in December.
The first couple months of the year could be volatile as investors assess potential spoilers, such as whether the new Trump administration limits its tariff battle to China or goes wider, which would hurt Japan’s export-dependent market. The size of the wage increases labor unions secure in spring negotiations is another risk.
But beyond the headlines, fund managers and strategists see potential positive factors. First, 2024 will likely turn out to have been a record year for corporate earnings because some companies have benefited from rising prices and increasing demand, as well as better capital allocation.
In a note to clients, BofA strategist Masashi Akutsu said the market may again focus on a shift in corporate behavior that has begun to take place in recent years. For years, corporate culture has been resistant to change but recent developments—a battle over Seven & i Holdings that pits the founding family and investors against a bid from Canada’s Alimentation Couche-Tard , and Honda and Nissan ’s merger are examples—have been a wake-up call for Japanese companies to pursue overhauls. He expects a pickup in share buybacks as companies begin to think about shareholder returns more.
A record number of companies have also delisted, often through management buyouts, in another indication that corporate behavior is changing in favor of shareholders.
“Japan is attracting a lot of activist interest in a lot of different guises, says Donald Farquharson, head of the Japanese equities team for Baillie Gifford. “While shareholder proposals are usually unsuccessful, they do start in motion a process behind the scenes about the capital structure.”
For years, money-losing businesses were left alone in large corporations, but the recent spate of activism and focus on shareholder returns has pushed companies to jettison such divisions or take measures to improve them.
That isn‘t to say it is going to be an easy year. A more protectionist world could be problematic for sentiment.
But Japan’s approach could become a model for others in this new world. “Japan has spent the last 30 to 40 years investing in business overseas, with the automotive industry, for example, manufacturing a lot of the cars in the geographies it sells in,” Farquharson said. “That’s true of a lot of what Japan is selling overseas.”
Trade volatility that hits Japanese stocks broadly could offer opportunities. Concerns about tariffs could drag down companies such as Tokio Marine Holdings, which gets half its earnings by selling insurance in the U.S., but wouldn’t be affected by duties. Similarly, Shin-Etsu Chemicals , a silicon wafer behemoth that sells critical materials, including to the chip industry, is another potential winner, Takeda says.
If other companies follow the lead of Japanese exporters and set up shop in the markets they sell in, Japanese automation makers like Nidec and Keyence might benefit as a way to control costs in countries where wages are higher, Farquharson says.
And as Japanese workers get real wage growth and settle into living in an economy no longer in a deflationary rut, companies focused on domestic consumers such as Rakuten Group should benefit. The internet company offers retail and travel, both of which should benefit, but also is home to an online banking and investment platform.
Rakuten’s enterprise value—its market capitalization plus debt—is still less than its annual sales, in part because the company had been investing heavily in its mobile network. But that division is about to hit break even, Farquharson says.
A stock that stands to benefit from consumer spending and the waves or tourists the weak yen is attracting is Orix , a conglomerate whose businesses include an international airport serving Osaka. The company’s aircraft-leasing business also benefits from the production snags and supply-chain disruptions at Airbus and Boeing , Takeda says.
An added benefit: Its financial businesses stand to get a boost as the Bank of Japan slowly normalizes interest rates. The stock trades at about nine times earnings and about par for book value, while paying a 4% dividend yield.
Corrections & Amplifications: The past year is expected to turn out to have been a record one for corporate earnings in Japan. An earlier version of this article incorrectly gave the time frame as the 12 months through March. Separately, Masashi Akutsu is a strategist at BofA. An earlier version incorrectly identified his employer as UBS.
