Weekly Musings –CME Fedwatch change for week to August 11, 2023

14 Aug 2023 , 05:50 PM

Unlike the previous week to August 04, 2023, the current week to August 11, 2023 was relatively less eventful in terms of the impact on the CME Fedwatch and the rate expectations. Also, the market did turn a little more hawkish in the sense that one more rate hike is being factored in for sure with an outside possibility of two more rate hikes of 25 bps each. For the week, CME Fedwatch reacted to 3 key pieces of data flows. A little over 2 weeks after the Fed announced its 25 bps hike in Fed rates, there were 3 key events that had a material impact on the CME Fedwatch. The first data point was the US inflation that come in higher by 20 bps at 3.2%. The second data point was the speech delivered by Fed governor, Michelle Bowman, in which she clearly underlined the possibility of more rate hikes. 

If one were to sum up the shifts in the CME Fedwatch probabilities in the latest week to August 11, 2023, the probabilities did not change much at the centre. However, the impact was visible in the edges. Now, it looks like the likely rate hike could be 25 bps with and outside possibility of 50 bps rate hike. The markets are almost reconciled that there would be no rate cuts, at least, till March 2024 and even after that, the rate cuts would at best be about 75 bps to 100 bps from the current levels. That means, the rates would still be meaningfully higher than pre-COVID levels, even after the levels normalize.

LONG RATE PAUSE MAY START A LITTLE LATER

After the Fed rates were hiked by 25 bps in July policy, the general expectation was that it would prefer a long pause rather than further rate hikes. However, that assumption has now come into question. The CME Fedwatch is not focused on a long pause but one more possible rate hike in the next two policies itself. Also, the markets are now factoring in a possibility that the terminal Fed rates may move to 6% or higher. The Fed rates are already in the range of 5.25%-5.50%. It has been an aggressive round of 11 rate hikes in just 16 months, effectively hiking the rates by 525 basis points. This also happens to be the highest level of Fed rates since 2001. What is intriguing is that the consumer inflation for July has bounced back by 20 bps to 3.20%, despite the PCE inflation falling to 3% and core PCE inflation to 4%.

If you combine the higher inflation and also the hawkish tone of Michelle Bowman, it looks very likely that rates may be hiked once more time, before the Fed thinks about a prolonged pause. In short, the long pause idea is off now and the CME Fedwatch is factoring in one more rate hike of 25 bps before the Fed goes into a long pause. That is also borne out by the recent decision by Moody’s to downgrade US banks, which is likely to make these banks wary of lending to consumers.

RECAP – CME  FEDWATCH FOR THE WEEK ENDED AUGUST 04, 2023

Here is a quick recap of how the CME Fedwatch looked like for the previous week, before the above data points on jobs and global growth macros were factored in.

Fed Meet	375-400	400-425	425-450	450- 475	475- 500	500-525	525-550	550-575	575-600
Sep-23	Nil	Nil	Nil	Nil	Nil	0.2%	87.0%	13.0%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	71.8%	25.9%	2.3%
Dec-23	Nil	Nil	Nil	Nil	Nil	8.8%	66.2%	23.1%	2.0%
Jan-24	Nil	Nil	Nil	Nil	3.4%	31.3%	49.2%	14.8%	1.2%
Mar-24	Nil	Nil	Nil	2.0%	19.6%	41.7%	29.3%	6.9%	0.5%
May-24	Nil	Nil	1.9%	18.8%	40.8%	29.8%	7.9%	0.8%	Nil
Jun-24	Nil	0.9%	9.7%	28.9%	35.7%	19.7%	4.6%	0.4%	Nil
Jul-24	0.7%	7.6%	24.4%	34.1%	23.5%	8.2%	1.4%	0.1%	Nil
Sep-24	7.1%	21.7%	32.6%	25.2%	10.6%	2.5%	0.3%	Nil	Nil

Data source: CME Fedwatch

What is it that influenced the CME Fedwatch for the previous week to August 04, 2023? Needless to say, the first big major data point was the Fitch downgrade of US debt by one notch from AAA to AA+. This happened to be the first time since 2011 that US debt ratings were cut. Fitch had pinned the blame on the worsening fiscal situation and weak governance. By weak governance, it implies the uncertainty and ambivalence surrounding the raising of the debt ceiling in the US. 

The second key data point was the unemployment data announced in that week for the previous month. The unemployment rate had fallen by 10 bps from 3.6% to 3.5%, which is actually growth positive and shows one step move closer to full employment. However, job creation fell sharply during the month, indicating the pressure of sustained hawkishness was being felt in new job creation. However, the markets did interpret this as a signal that the Fed had managed to control inflation without impacting growth.

Lastly, global data flows in terms of macro data from the Euro Zone and China showed pressure on growth with negative implications for global demand. 

HOW CME FEDWATCH SHIFTED IN THE WEEK TO AUGUST 11, 2023

The week to August 11, 2023 had 3 critical data points and each had a different degree of impact on the CME Fedwatch during the week. There was the inflation announcement, the speech by governor Michelle Bowman and the downgrade of US banks by Moody’s, in the aftermath of the downgrade of US debt by Fitch.

Fed Meet	375-400	400-425	425-450	450- 475	475- 500	500-525	525-550	550-575	575-600
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	90.0%	10.0%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	63.1%	33.9%	3.0%
Dec-23	Nil	Nil	Nil	Nil	Nil	8.1%	59.3%	29.9%	2.6%
Jan-24	Nil	Nil	Nil	Nil	2.5%	24.0%	50.2%	21.5%	1.8%
Mar-24	Nil	Nil	Nil	1.2%	12.8%	36.6%	36.4%	12.0%	0.9%
May-24	Nil	Nil	1.0%	10.7%	32.2%	36.4%	16.5%	3.0%	0.2
Jun-24	Nil	0.5%	5.5%	20.6%	34.2%	27.3%	10.3%	1.7%	0.1%
Jul-24	0.3%	4.2%	16.7%	30.7%	29.0%	14.6%	3.9%	0.5%	Nil
Sep-24	3.7%	14.2%	27.9%	29.4%	17.5%	6.0%	1.2%	0.1%	Nil

Data source: CME Fedwatch

Let us turn to the 3 factors that had an impact on the CME Fedwatch during the current week to August 11, 2023.

1. US consumer inflation for July 2023 came in 20 bps higher at 3.2% compared to 3% in the previous month. That was surprising since the PCE inflation had also fallen to 3% in the month of June. However, the fact is that this spike in inflation takes the market further away from its avowed inflation target of 2%. This is likely to be supportive of the hawks within the Federal Reserve.

    

2. The second major data point was the speech by governor Michelle Bowman, which largely focused on why the Fed should get more hawkish. The gist of the speech by Michelle Bowman was that one more rate hike was inevitable and the markets should also be prepared for the possibility of another rate hike taking the rates to the range of 5.75% to 6.00%. That is visible in the way the CME Fedwatch has shifted in the week.

    

3. Finally, the rating downgrade by Moody’s of US banks was also a major factor. However, this could have a positive effect. Here is why. For instance, when banks are downgraded, most of these banks are likely to get wary and preserve capital for regulator needs than for expanding credit. To an extent that will work like a subtle for of credit tightening, so the Fed would probably be able to do away with more rate hikes. We have to wait and watch, how this pans out.

When it comes to the CME Fedwatch, a lot can change in a week’s time. From betting on a long pause, the CME Fedwatch has shifted to one more rate hike before a long pause. However, the bank downgrade could have a soothing effect on the Fed as the credit tightening would act as a proxy for a rate hike. That could hold the key.

TRIGGERS FOR CME FEDWATCH TO TRACK IN COMING WEEK

The coming week has 3 important data points which will have a bearing on the CME Fedwatch. Here is a quick look at the 3 triggers for the coming week.

1. FOMC member, Neil Kashkari, speaks during the week and he has normally tilted towards a more dovish approach to rates. He has generally favoured keeping interest rates low to encourage growth unless inflation really becomes a major issue, like it had become in late 2021. That is likely to help the CME Fedwatch to sober this week.

    

2. On August 16, 2023, the Federal Reserve will publish the all-important Fed minutes. These are released by the Federal Reserve after a gap of 3 weeks of announcing the policy statement. While the July statement had hiked rates by 25 bps, what we do not know is the debate behind this decision and the dot plot chart underlying the decision. That would give a clearer picture of how many more rate hikes to expect and for how much longer.

    

3. Fed will publish its balance sheet data on August 17, 2023. This data point will be critical as it would show how much of bonds the Fed still holds. In its previous announcement, the Fed balance sheet size was at $8.2 trillion and it remains to be seen if it has fallen below the $8 trillion mark. The taper can also act as a substitute for rate hikes by the US Federal Reserve.

The big discussion point in the coming week will be whether the bank downgrade by Moody’s and the Fed balance sheet reduction would act as a substitute for rate hikes by the Fed in future. We have to wait and watch!

WHAT INDIA WILL FOCUS ON THIS WEEK?

Indian markets, as well as RBI keep a close watch on the shifts in the CME Fedwatch as it gives market-friendly picture of which way the monetary winds are blowing. For India, the higher US inflation would come as a relief since Indian inflation is also expected to be higher in the months of July and August. One thing the Indian policy makers would be closely watching is the combined impact of Fed tapering of its balance sheet and the US bank downgrade by Moody’s. Put together, they have the ability to constrain global liquidity flows and that is already evident in the way FPI flows have fallen drastically. At a time when inflation is rising, tightening liquidity would be a double whammy, that India would be wary about. That is surely not a situation that India would relish.