Weekly Musings – CME Fedwatch change for week to December 22, 2023

24 Dec 2023 , 10:07 AM

US INFLATION MOVE CLOSER TO THE 2% TARGET

Just a week after the Fed turning dovish and guiding for rate cuts, the inflation data has also been very supportive. Just a week ago, the Fed statement had clearly given a hint of 3 rate cuts of 25 bps each in 2024 and another 4 rate cuts of 25 bps each in 2025. Just a week after the dovish outlook given by the Fed, the PCE inflation was a very supportive. The PCE inflation at 2.6% is one of the lowest in recent memory. 

The lower PCE inflation was triggered by a fall in food, energy, and core inflation in November. At 2.6%, the PCE inflation for November is 40 bps below the October level and 80 bps below the September level. Since April 2023, the PCE inflation has fallen by a full 180 basis points and that is a sure indication that low inflation is here to stay. With this fall, the PCE inflation is now just about 60 bps away from the long term inflation target of 2% for the US Federal Reserve.

HOW LOW PCE INFLATION OPENS UP 3 SCENARIOS FOR THE FED

With the PCE inflation sharply lower in November at 2.6%, it opens up 3 possibilities for the Fed. While the Fed may stick to its dovish stance and rate guidance for now, there are three scenarios that are possible. The first scenario is that the Fed may use the lower rates of inflation to front-end the rate cuts. The CME Fedwatch is already guiding that the entire 175 bps of rate cuts would happen by end of 2025 itself. 

The second scenario is that the Fed may look at steeper rate cuts. In the US, 2.5% rate of interest is considered to be the neutral rate and any rate above that is known to impact growth. The Fed may look to take the rate of interest closer to the neutral levels. Finally, it is also possible that the Fed may look to magnify the rate cuts impact, either by infusing more liquidity in the system or by slowing down the winding down of the bond book. It could take any of the forms, going ahead.

LONG TERM FED PROJECTIONS ALREADY TURNED DOVISH

The Federal Open markets Committee (FOMC) had released its long term estimates on key macroeconomic variables with the December policy statement. There were interesting updates to the Fed projections in the December update, compared to the September update. The big shift this time was in the GDP estimates. In June, the GDP estimate for 2023 was 1.1%, which was raised to 2.1% in September. In the December estimates, the Fed has raised the estimate of growth to 2.6%; a full 150 bps higher than June. With the hard landing now ruled out, the inflation is also expected to move quickly towards the 2% target. The dot plot chart has also built in substantial dovishness in rates in the next two years.

RECAP – CME  FEDWATCH FOR THE WEEK ENDED DECEMBER 15, 2023

The previous week to December 15, 2023 saw CME Fedwatch clearly veering towards a more aggressive approach to rate cuts. While the Fed, at that point, had just factored in 2 rate cuts by end of 2024, the CME Fedwatch had already factored in up to 4-5 rate cuts by the end of 2023. Now, the Fed is factoring in 3 rate cuts by end of 2024 and 7 rate cuts by end of 2025, the CME Fedwatch is betting on 6 to 7 rate cuts by the end of 2024 itself.

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Jan-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	10.3%	89.7%
Mar-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	6.8%	62.7%	30.5%
May-24	Nil	Nil	Nil	Nil	Nil	Nil	5.6%	52.9%	36.1%	5.3%
Jun-24	Nil	Nil	Nil	Nil	Nil	5.1%	48.6%	37.7%	8.2%	0.5%
Jul-24	Nil	Nil	Nil	Nil	4.3%	41.9%	39.3%	12.7%	1.7%	0.1%
Sep-24	Nil	Nil	Nil	3.8%	37.4%	39.6%	15.9%	3.0%	0.3%	Nil
Nov-24	Nil	Nil	2.5%	25.9%	38.9%	24.0%	7.4%	1.2%	0.1%	Nil
Dec-24	Nil	2.0%	21.3%	36.3%	27.0%	10.7%	2.4%	0.3%	Nil	Nil

Data source: CME Fedwatch

The previous week was a watershed in that it marked the first shift of the Fed from a hawkish stance to a clearly dovish stance. There were 3 data points that had an impact on the CME Fedwatch in the previous week to December 2015, 2023. 

• The CPI inflation for November 2023 came in marginally lower at 3.1%, against 3.2% in October 2023. This was largely in line with the Bloomberg estimates, although the market trades were expecting the consumer inflation to optimistically touch 3% or even dip below that. While core inflation remained flat in the month, it was the food inflation and the fuel inflation that actually pushed the inflation lower by 10 bps.

   

• The December 2023 Fed policy was announced on December 13, 2023. While the Fed maintained status quo on rates (as was expected), the big shift was in the dovishness. For the first time, the Fed gave a clear indication that there would be 3 rate cuts of 25 bps each in 2024 and another 4 rate cuts of 25 bps each in 2025. That makes it total of 175 bps of rate cuts at the bare minimum by end of 2025. This was the first, and clearest signal from the Fed that rate hikes are done. It is also, possibly, bidding farewell to the hawkish stance, which had largely outlived its utility. That shift has finally happened in the December Fed statement during this week.

   

• Along with the December policy statement, the FOMC (Federal Open Markets Committed) also released the December quarter projections update of key macro variables. The updated data showed that actual GDP growth in 2024 and 2025 will be higher than expected, while inflation would be lower than expected. As a result, the perfect for a rate cut were already there.

On its part, the Fed statement was the big story this week and also the watershed moment in the Fed policy timeline. For the first time, the Fed signalled a shift away from its hawkish stance and promised to turn neutral to dovish in the next 2 years. 

CME FEDWATCH IN THE LATEST WEEK TO DECEMBER 22, 2023

The week to December 22 had some major data points. With the last week being a week of Christmas and New Year holidays, the GDP update and the PCE inflation data were moved to the current third week. These were the data points that set the tone for the CME Fedwatch in the current week. 

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Jan-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	14.5%	85.5%
Mar-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	12.4%	75.6%	12.0%
May-24	Nil	Nil	Nil	Nil	Nil	0.4%	14.5%	73.6%	11.6%	Nil
Jun-24	Nil	Nil	Nil	Nil	2.1%	21.4%	66.2%	10.2%	Nil	Nil
Jul-24	Nil	Nil	Nil	1.9%	20.1%	63.1%	14.1%	0.7%	Nil	Nil
Sep-24	Nil	Nil	1.7%	18.3%	58.8%	19.0%	2.1%	0.1%	Nil	Nil
Nov-24	Nil	1.0%	11.2%	41.5%	36.0%	9.3%	0.9%	Nil	Nil	Nil
Dec-24	0.8%	8.8%	34.4%	37.3%	15.5%	2.9%	0.2%	Nil	Nil	Nil

Data source: CME Fedwatch

There are 3 critical triggers to watch out for in the coming week to December 22, 2023 with reference to CME Fedwatch. Due to the Christmas weekend, most of the key US data flows will now happen in the third week instead of the fourth week.

• On December 21, 2023, the third and final estimate of Q3 GDP was put out by the Bureau of Economic Analysis (BEA). In the second estimate, the GDP had been upped by 30 bps to 5.2%. The third estimate reverted back to 4.9%, with gains coming from lower inflation, despite weak nominal GDP growth compared to the second GDP estimate.

   

• On December 22, 2023, the PCE inflation estimate for November came in sharply lower at 2.6%. It was 3.0% in October and 3.4% in September. The sharply lower PCE inflation takes it much closer to the 2% target and it also means that the Fed may look at intensifying its dovishness; either by sharper rate cuts or by front-ending rate cuts.

   

• The Q4 Atlanta Fed GDP estimate towards the end of the week saw a sharply lower estimate of 2.3%, compared to 2.7% at the start of the week. The weakening is an indication that the Q4 GDP could be weaker than originally expected. However, it is unlikely to substantially impair the full year GDP growth projection of 2.6%.

While the GDP growth is work in progress, it is the sharply lower PC inflation that is likely to be the more significant factor impacting the CME Fedwatch. If anything, the lower PCE inflation is only going to reinforce the dovishness of the Federal Reserve.

TRIGGERS FOR CME FEDWATCH TO TRACK IN WEEK TO DECEMBER 29, 2023

There are 3 critical triggers to watch out for in the coming week to December 29, 2023 with reference to CME Fedwatch. Of course, it would be a relatively quiet week considering that most Americans would be in the midst of Christmas and New Year holidays. Here are some key triggers in the coming week.

• The consumer spending has been a key driver of the US economy and if the current growth rate has to be sustainable, that consumer spending has to be pick up. The coming week will give the first signals of how the consumer spending pans out in the Christmas shopping week. This week normally sees consumer spending peak.

   

• The API stocks would be closely watched for signals on oil prices last week, the oil stocks were expected to see a sharp fall, but instead expanded by 0.939 million barrels. If the current week also sees expansion in stocks, then we could see down ward pressure on crude oil prices. Developments within the OPEC could also pull down oil prices.

   

• With the last week of the year being low on data, the markets will be closely watching the US bond yields and the US dollar index (DXY). Last week, US bond yields fell to 3.9% and the dollar index to 101 levels. If the downtrend continues, the CME Fedwatch will take it as a signal that dovishness is not only here to stay, but it is being front-ended.

For now, all eyes will be on the consumer spending during the Christmas week as it will set the tone for consumer spending reading for the coming quarter.

CME FEDWATCH VS FED STANCE: DICHOTOMY GETS REAL

It looks like the CME Fedwatch had the upper hand this time around as it managed to pre-empt the Fed to follow its starkly dovish expectations. Here is how the dichotomy between the CME Fedwatch and the Fed stance looks now.

• On the upside, there appears to be a reasonable consensus. It looks like rate hikes are done and dusted and while the Fed has not committed to any time line, the CME Fedwatch expects the first rate cut to manifest as early as March 2024 itself.

   

• What about terminal rates? That is an area where there is almost a consensus. The Fed may not have said in so many words, but it is clear that they do not intend to take up any more rate hikes. More so, with the PCE inflation already at 2.6% in November.

   

• The real big dichotomy is on the downside. While the Fed has now reconciled itself to 3 rate cuts in 2024 and 4 rate cuts in 2025, the CME Fedwatch expects front ending. The CME Fedwatch expects all the 7 rate cuts of 25 bps each to happen in the year 2024 itself, with an outside possibility of even 8 rate cuts happening. Of course, the CME Fedwatch does not give a very clear indication beyond one year. 

Eventually, Fed would still prefer to be data drive; and that is what they will continue to do. Certainly, the Fed has bid goodbye to any form of hawkish ambivalence!