Which Central Bank Will Cut Interest Rates First? | David Woo

2024 was supposed to be the year that the US dollar bites the dust. So far the dollar is hanging in there, defying market consensus. A weak dollar requires lower US interest rates. However, the continued resilience of the US economy is not giving the Federal Reserve an excuse to start cutting interest rates. However, 2024 is still young. In the realm of global economics, interest rates and currency exchange dynamics are subject to intense scrutiny. The latest OECD Labor Productivity Data sheds light on the labor productivity disparities among OECD countries, shaping investment attractiveness and financial market sentiments. As Christine Lagarde ECB deliberates over ECB interest rate decisions, Wall Street forecasts scrutinize the potential USD outlook against the backdrop of economic resilience and interest rate differentials. The factors supporting the USD amidst the BOJ interest rate policy and People’s Bank of China maneuvers highlight the complex network of financial conditions influencing the dynamics between USD, JPY, EUR, and RMB. Amidst discussions on Labor Compensation Trends and Hourly Wage Growth OECD indicators, questions linger regarding the Economic Impact of COVID-19 and the trajectory of Job creation against Unemployment Rates in Europe, particularly as the Euro Unemployment Rate hits a record low. Meanwhile, AI adoption and collective bargaining influences loom large over labor market tightness and wage growth, painting a nuanced picture of the ECB Interest Rate Path in contrast to US inflation pressures and USD vs JPY vs EUR outlooks. As discussions unfold on potential interest rate cuts, the spotlight turns to major central banks and their strategies. Will the Bank of Japan or the ECB be the first to make a move, and what factors will drive their decisions? Which currencies will do well and which poorly? And what does productivity growth have to do with it? David Woo, a former top-ranked Wall Street global macro strategist, tells it as it is. You may not agree with everything he says but he will make you reassess everything you thought you knew.

#centralbank #interestrates #usdollar

0:00 Intro
1:01 Who Will Cut First?
2:50 What are the clues?
5:39 Wage Growth
7:05 What About Labor Cost?
8:44 What Do the Numbers Tell Us?

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2024 was supposed to be the year  that the US dollar bites the dust  So far the dollar is hanging in  there, defying market consensus  A weak dollar requires lower US interest rates But the continued resilience of the US economy   is not giving the Federal Reserve an  excuse to start cutting interest rates 

However, 2024 is still young Which major central bank will   be the first to cut interest rates and why? Which currencies will do well and which poorly?  And what does productivity  growth have to do with it? For the dollar to go down, either the  euro, the second most traded currency,  

Or the RMB, the currency of the second largest  economy in the world, or both have to go up.  Given the importance of interest rate  differential as a driver of exchange rates,   for that to happen, the Federal Reserve  will have to cut interest rates ahead of  

The European Central Bank and or the People’s  Bank of China and cut more aggressively.  I have argued in another video that  China should not wait for the Fed to   cut interest rates (Chart 1) But what are the chances that   the Fed will cut before the ECB? Continued US growth outperformance  

Suggests the chances are slim. US GDP growth averaged 1% in the   second half of 2023 and is expected  to be 0.6% this quarter. (Chart 2)  Eurozone GDP didn’t grow at all in the  second half of 2023 and is expected to  

Increase by only 0.1% this quarter. (Chart 2) However, despite the underperformance of the   Eurozone economy, the ECB seems distinctly  less enthusiastic about bringing down   interest rates than the Federal Reserve. While Christine Lagarde, the ECB President,   reiterated this week at a conference of ECB  watchers that the ECB would consider bringing  

Down interest rates in June, she refused to commit  to a particular path of interest rates after that.  In contrast, this week the Federal Open Market  Committee did not change its forecast of 3   cuts for 2024 despite the fact that inflation has  surprised to the upside over the past two months. 

Wall Street is taking its cues from the central  banks. The market is pricing a little more than   3 cuts for the Fed and a little less  than 3 cuts for the ECB. After that,   it is pricing that the same  interest rate differential will   persist in 2025 (Chart 3). Does this make any sense?

Two key indicators encapsulate the  most crucial differences between   the major economies at present, at least  as far as monetary policy is concerned.  One is labor productivity,  defined as GDP per hour worked.  The other is labor compensation per hour worked. What you see on this chart is the year on  

Year change of labor productivity of a  selection of OECD countries. (Chart 4)  The data are from the third quarter of  2023, the latest quarter comparable data   from the OECD is available. (Chart 4) The most striking part of this chart   is the disparity of labor productivity  growth across these countries. (Chart 4) 

At one end we have Japan, the US,  Israel and South Korea that saw an   increase in labor productivity. (Chart 4) At the other end, we have Australia,   Canada, Italy and Germany that witnessed a  decrease in labor productivity. (Chart 4) 

Labor productivity is a measure of economic  efficiency. It goes up when the same amount   of labor input produces more goods and services. Labor productivity growth is the most important   source of economic growth because it is the  ultimate driver of per capita income and the  

Main determinant of the absolute and relative  standards of living in different countries.  The fact that it is still going up in Japan and  in the US at this late stage of the business cycle   is a big positive for these countries. The fact that is going down in Europe,  

Canada and Australia is a concern. What should be an even bigger concern   for Europeans, Canadians and Australians is  that what happened in the third quarter of   last year was nothing more than a continuation  of a pattern that started with the pandemic. 

For whatever reason, COVID and the Russia-Ukraine  war have resulted in a significant divergence in   the level of labor productivity between countries What this chart shows is that labor productivity   has increased by 5% in the US since the  end of 2019 and by 3% in Japan. (Chart 5) 

At the other extreme, labor productivity has  declined 4% in France since the end of 2019   and nearly 2.5% in Australia. (Chart 5) This means that US labor productivity   has increased by nearly 10% relative  to French labor productivity in the   space of just 4 years. (Chart 5) Economic theory tells us that,  

All else being equal, countries with  higher labor productivity growth should   have also higher return on capital. This means  they will have higher real interest rates.  In this respect, the high labor productivity  growth in the US should be viewed as a  

Major support for the USD and US equity  outperformance over the past two years.   Now let’s turn to labor  compensation per hour worked.  What you see on this chart is the year on  year change of labor compensation per hour  

Worked in the third quarter last year. (Chart 6) Once again, you can see that the range among our   sample of OECD countries is very wide. (Chart 6) At one extreme, we have Hungary and Australia   with relatively high wage growth. (Chart 6) At the other end, we have Japan and Switzerland  

With relatively low wage growth (Chart 6). Between the two extremes we have Germany,   France, Italy, Canada, and the US,  with US hourly compensation growth   lower than that of the others (Chart 6). In theory, wage growth should be a function   of how tight the labor market is. However, it is not clear the fact  

That wage growth in Europe was higher  than wage growth in the US in 2023 was   because labor market was tighter in Europe. My guess is that the greater importance of   collective bargaining in Europe had more to  do with it. Also labor hoarding could be more  

Prevalent in Europe than in the US. Whatever might have been the reason,   with the unemployment rate in Germany and  France rising (Chart 7), my expectation is   that wage growth in Europe will  moderate considerably in 2024. When we divide hourly compensation by  labor productivity, we get unit labor cost. 

Unit labor cost is a measure of the labor cost  associated with producing one unit of GDP.  When labor productivity growth is low and wage  growth is high, unit labor cost growth is high.  When labor productivity growth is high and wage  growth is low, unit labor cost growth is low. 

What you can see on this chart is that unit  labor cost growth is higher in Australia,   UK, Germany than in Japan, Korea,  the US and Switzerland. (Chart 8)  On this chart, I have plotted the times series  of unit labor cost growth for the US, Japan,  

And Germany over the past five years. (Chart 9) What you can see is that Japanese unit labor   cost growth had returned to zero by  the third quarter of last year. This   explains why the BOJ took its time to exit  from negative interest rates. (Chart 9) 

Similarly, unit labor cost growth in the US  was back down to 2%, close to the pre-pandemic   level (Chart 9). This is one reason why  the Fed is so confident about inflation   returning to its 2% target soon. (Chart 9) In contrast, unit labor cost in Germany,  

Which had been accelerating since the end of 2022,   was still running at 3 timed the rate as in the  US in the third quarter of last year (Chart 9).  High unit labor cost growth is probably the  single most important reason why the ECB and  

The Bank of England have kept interest rates  high despite near recessionary conditions. What do the above analysis tell us about  the outlook for interest rates and exchange   rates for the major economies in 2024? Low unit labor cost growth makes it   easier for companies to maintain if  not to expand their profit margins. 

In this respect, the relatively low unit  labor cost growth in the US and Japan make   these economies more attractive for investment. The latest Business Roundtable survey shows a   surge in capex intention in the US (Chart 10) This should help support job creation  

And keep the labor market tight. In the case of Japan, a pickup in   wage growth (Chart 11) has allowed the BOJ to exit  from negative interest rates finally. The BOJ will   have room to raise interest rates further in the  coming months as inflation stabilizes around 2%. 

In the case of the US, this could mean that  4% unemployment rate and 4-5% wage growth are   here to stay. This means even if the Fed were to  start cutting interest rates in June as expected,   the cuts won’t be very deep as the economy  will likely avoid going into a recession. 

For now, I am assuming that the current above  trend labor productivity growth continues,   with the help of AI adoption (Chart 12) In the case of the eurozone, the unemployment   rate ticked down to 6.4% in January from 6.5% in  December. This is the lowest level recorded since  

The introduction of the euro in 1999 (Chart 13) What this says is that the high unit labor cost   growth is not yet putting a brake on hiring. I suspect that labor shortage in 2022 and 2023   is encouraging labor hoarding behavior Indeed, a new European Commission Survey  

Shows elevated levels of labour hoarding,  especially in Germany and France. (Chart 14)  But this cannot be sustainable,  as profit margins of European   companies come under increasing pressure My guess is that labor hoarding in Europe   will gradually unwind in 2024 and that  wage growth will slow faster in Europe  

Than in the US in the remainder of this year. If I am right, the ECB will end up cutting   interest rates more aggressively than the Fed My view also reflects the risk that the Fed has   not yet gotten inflation under control and that  with financial conditions too easy US interest  

Rates will stay higher for longer. I continue to see more   upside than downside for the USD Of the major currencies, my expectation for   the rest of 2024 is that the USD will outperform  the JPY which will outperform the EUR and the RMB.