European Central Bank cuts interest rates, diverging from the Fed

• "We are at the beginning of a new regime in central banks, as many major central banks start to ease policy ahead of a very timid Fed," James Rossiter, head of global macro strategy at TD Securities, wrote in a note.
• But major questions remain, including whether the ECB will be able to continue cutting and when the Fed might join the club.

Driving the news: The ECB lowered its key policy rate a quarter-point to 3.75%, the first rate cut in nearly five years, taking the rare step of front-running the Fed. Central banks in Switzerland, Sweden and the Czech Republic have already done the same.

What they're saying: "Although we were quite coordinated on the way up — and that was really helpful because a big part of inflation was global — you're going to see some divergence on the way down, and that makes sense," top Bank of Canada official Carolyn Rogers told reporters Wednesday.

ECB president Christine Lagarde hinted as much at a press conference Thursday morning, noting that she "wouldn't volunteer" that the ECB is definitively entering the phase of dialing back rates.

• "We need data to confirm we're on the disinflationary path," Lagarde said. The ECB rate cut came alongside new projections that raised forecasts for inflation this year and next.
• "The ECB is drawing a clear distinction: The next few decisions are about dialing back, not necessarily starting a proper cutting cycle," economists at Bank of America wrote in a note this week.

What to watch: Central banks are mandated to adjust rates based on conditions in their respective economies.

• But there are worldwide spillovers from such decisions, particularly currency moves, that make them more cautious about diverging too much from other major central banks.
• Bank of Canada governor Tiff Macklem acknowledged that there is a limit to how much its policy can diverge from the Fed. "I don't think we're close to that limit," Macklem said at a press conference Wednesday.
• "There's no sort of bright line, and you can see from history there have been periods of considerable divergence," Macklem added.

Central banks in major economies are cutting interest rates for the first time since the inflation shock. What's unclear is whether those cuts ultimately bring rates back to anywhere near rock-bottom levels seen in the 2010s.

• "This is not your typical rate cutting cycle. Central banks are set to keep rates above pre-pandemic levels," as inflationary pressures persist, analysts at the BlackRock Institute wrote earlier this week.

While the Fed is unlikely to change policy at its meeting next week, there has been a recent shift in bond market sentiment toward the idea that rate cuts are indeed on the way.

By the numbers: The two-year Treasury yield, sensitive to the near-term outlook for Fed policy, fell from 4.99% on May 29 to 4.73% Thursday morning.

• The CME's FedWatch tool, based on futures prices, puts 68% odds on at least one rate cut by the Fed's September meeting — versus about 50% a week ago.

Of note: The shift hasn't come thanks to any major new communications from Fed officials (who are in their customary pre-meeting blackout period this week) or narrative-shifting economic data releases.

• Rather, a drumbeat of data points seemingly affirms that a gradual slowdown and disinflation process remains underway.
• That includes last week's data on consumption spending and PCE inflation and readings this week on job openings and manufacturing.

What's next: The days ahead, however, will offer a slew of major data and Fed communications that could either upend that story or confirm it.

• First up is the May jobs report, out Friday. Wednesday morning, the May Consumer Price Index is out. And Wednesday afternoon, the Fed announces its policy (non-)move, along with new economic projections and a news conference from chair Jerome Powell.

The bottom line: Six days from now, we'll know a lot more than we do now about when the Fed will join the Europeans and Canadians in loosening policy.