For the past two years, most of the world’s central banks were in sync, raising rates and then keeping them high to combat post-pandemic inflation. Now, although inflation has come down globally, some central banks, such as the European Central Bank (ECB), are looking at cutting rates sooner and more aggressively than other central banks such as the Fed. Still, when the Fed does cut rates, it will impact currency markets and U.S.-based companies with international business.
As of its March meeting, the U.S. Fed’s Federal Open Market Committee (FOMC) was still projecting around three rate cuts in 2024, and markets were anticipating that the first cut could come in June. Although that’s still the case overall, the final stretch of the road to 2% inflation has been rockier than many hoped. This somewhat-persistent inflation has led some FOMC members to take a more cautious approach to cutting rates. For example, Federal Reserve Governor Christopher Waller recently noted that it may now be more appropriate to reduce the overall number of rate cuts or to push them further into the future. “Shorter-term inflation measures are now telling me that progress has slowed and may have stalled,” he reportedly said.
Meanwhile, markets are projecting that the ECB will take a more aggressive approach to cutting rates this year. We’re already seeing this difference in projected monetary policies between the ECB, Fed and Bank of England impact the euro, which has been struggling against both the U.S. dollar and the British pound in 2024.
How to prepare for rate cuts
If we just consider the Fed, the Bank of England and the Bank of Canada, the timing of rate cuts could differ considerably as inflation expectations in these three economies play out. Right now, there is a good chance that both the Bank of England and the Bank of Canada will start cutting rates in June. If they do and the Fed does not, both the British pound and the Canadian dollar would decline slightly against the U.S. dollar—in fact, markets are already pricing in this scenario so the impact on currency markets is likely to be small.
However, when the Fed does start to cut rates, the U.S. dollar will probably be sold off against other currencies. Since the U.S. dollar has been so strong, a slight sell-off is unlikely to make much of an impact and, moreover, it can even be seen as a sign that the global economy is perceived to be healthier than it was before because it means that markets feel comfortable enough to move out of the “safe-haven currency.”
Still, U.S. companies doing business internationally should prepare for the ripple effect to currency markets. If you have large upcoming purchases planned to buy from outside the U.S.—especially in Europe, the U.K. and even in Canada—understand that those countries’ currencies are likely to gain against the U.S. dollar when the Fed starts to cut rates. One way to prepare for this is to hedge ahead of time—before it becomes costlier to make purchases in those countries—and lock in a currency rate now.
Meanwhile for U.S. companies on the other side of that equation and selling into these other countries, the decline in the U.S. dollar against international currencies will be positive because they will be making more dollars when selling the same products.
Onshoring helping Mexican peso
Much of what we’re seeing today can be attributed to the Covid pandemic—whether it’s the inflation that central banks such as the Fed have been fighting or China’s struggles to rebound. Yet the opposite has been true for Mexico, which has benefitted from the current landscape. The supply chain disruptions that were wrought by the pandemic encouraged many U.S. companies to onshore manufacturing either back in the U.S. or in Mexico.
As a result, foreign direct investment (FDI) in Mexico has increased substantially, with FDI at the end of 2023 27% higher than it was at the end of 2022. Nearly 40% of the FDI coming into Mexico last year was from the U.S., making it the main country investing in Mexico. Also last year, Mexico surpassed China as the largest exporter to the U.S for the first time in over twenty years. These developments have all been good for the Mexican Peso, which has been experiencing multiyear highs versus the U.S. dollar.
Inflation rates are moving lower
Looking forward, rate cuts will probably be the story of 2024. Higher interest rates around the globe have certainly helped tame higher prices but for now the inflation targets for most central banks, especially the Fed, are still some way off.
. © 2024 BOKF, NA.