Weekly Musings – CME Fedwatch change for week to June 28, 2024

1 Jul 2024 , 10:38 AM

WHY FED RATE CUTS MAY FINALLY BE A REALITY

There were two important pieces of data in the US this week. The first data point was the third and final estimate of GDP growth for the first quarter of 2024. That came in at 1.4%. It was higher than the second estimate, but sharply lower than the third and fourth quarters of 2023, when the US economy recorded stupendous growth rates of 4.9% and 3.4% respectively. The sharp fall in GDP growth was the first indication that the growth is tapering according to the Fed plan and the rate hikes have done their job. The second data point came from the PCE inflation, which showed the price hike in May down to 2.6% on the back of lower food and core inflation. However, energy inflation continues to be the pain point. The table below captures the break-up of the PCE inflation for the month of May 2024 and a comparison of the last 8 sequential months.

Break-up of PCE Inflation (YOY)	Oct-23	Nov-23	Dec-23	Jan-24	Feb-24	Mar-24	Apr-24	May-24
Headline PCE Inflation (Year on Year)	2.9	2.7	2.6	2.5	2.5	2.7	2.7	2.6
Goods	0.2	-0.1	0.2	-0.5	-0.2	0.1	0.1	-0.1
Durable goods	-2.2	-2.1	-2.3	-2.4	-2.0	-1.9	-2.2	-3.2
Nondurable goods	1.6	1.0	1.6	0.5	0.8	1.3	1.4	1.6
Services	4.3	4.1	3.9	4.0	3.9	4.0	4.0	3.9
Addenda:
Core PCE excluding food and energy	3.4	3.2	2.9	2.9	2.8	2.8	2.8	2.6
Food	2.4	1.7	1.4	1.4	1.3	1.5	1.3	1.2
Energy goods and services	-4.6	-5.0	-1.7	-4.9	-2.3	2.6	3.0	4.8

Data Source: US Bureau of Economic Analysis (BEA)

Here are some important takeaways from the PCE inflation story for May 2024 and then we shall see why it makes a case for an early rate cut by the Fed.

• Inflation based on personal consumption expenditure (PCE) came in at 2.6% for May 2024. The important point is that it has shown a secular downward trend since April 2023. If you further break up the goods inflation, the real fall in inflation is coming from durable goods inflation which has dipped from -2.2% to -3.2% in May 2024. In the same period, the inflation in non-durable goods (largely pharmaceuticals) is up from 1.4% to 1.6%, while the services inflation was marginally down from 4.0% to 3.9%. Clearly, most of the downward pressure on the PCE inflation is thanks to durable goods; with the non-durable goods and services not helping inflation come down too much.
• Letu us first look at the good news on the inflation front; coming from core inflation and food inflation. The residual core inflation (excluding food and energy) was 20 bps lower at 2.6% in May with the gains of the supply chain constraints rectifying still visible. In fact, the core PCE inflation has shown a consistent downtrend from June 2023 till May 2024; falling 170 bps from 4.3% to 2.6%. Apart from the core inflation, even the PCE food inflation for the month was fell from 1.3% to 1.2%. However, the real problems lies in the third basket of energy inflation.
• Energy inflation continues to be the gist of the inflation problem in the US, largely on account of the Red Sea crisis and the geopolitical risk in the Middle East and West Asia putting pressure on oil prices. In addition, the decision by Russia to curtail oil supplies is also having an impact on the global oil prices; with Brent crude back to $86/bbl. If you see between January 2024 and May 2024, the PCE energy inflation has spiked from a low of -4.9% to +4.8% (a spike of 970 bps). The story of the last mile inflation in the US is now entirely about energy inflation.

But, what does this mean for Fed rate action? We have to see the PCE inflation data in conjunction with the GDP data for Q1. Lower than expected GDP growth and tepid PCE inflation make the perfect case for the Fed to commence rate cuts. Oil inflation is still high, but as past experience has shown, oil is never a secular problem and should rectify on its own. That means, the setting is perfect for the Fed to cut rates in September FOMC meeting as expected. Or, the Fed may even surprise the street with a pre-emptive rate cut in the July 31, 2024 FOMC meeting itself. We have to wait and watch!

RECAP – CME  FEDWATCH FOR THE WEEK ENDED JUNE 21, 2024

Let us start with a recap of the week to June 21, 2024; and how the CME Fedwatch panned out during the week. The undertone of members was still hawkish as the last mile inflation was the challenge. Here is how the CME Fedwatch chart looked in the previous week; ahead of the GDP data and the PCE inflation data.

Fed Meet	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550	550-575
Jul-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	10.3%	89.7%	Nil
Sep-24	Nil	Nil	Nil	Nil	Nil	Nil	6.4%	59.5%	34.1%	Nil
Nov-24	Nil	Nil	Nil	Nil	Nil	2.3%	25.1%	50.6%	22.1%	Nil
Dec-24	Nil	Nil	Nil	Nil	1.7%	19.9%	44.7%	28.6%	5.1%	Nil
Jan-25	Nil	Nil	Nil	1.0%	12.6%	34.7%	35.1%	14.5%	2.0%	Nil
Mar-25	Nil	Nil	0.7%	8.7%	27.3%	35.0%	21.4%	6.2%	0.7%	Nil
Apr-25	Nil	0.3%	4.5%	17.5%	30.9%	28.5%	14.2%	3.6%	0.4%	Nil
Jun-25	0.2%	2.9%	12.5%	25.8%	29.5%	19.7%	7.7%	1.6%	0.1%	Nil
Jul-25	1.4%	6.7%	17.8%	27.3%	25.6%	15.0%	5.3%	1.0%	0.1%	Nil
Sep-25	6.6%	15.2%	25.1%	26.0%	17.4%	7.5%	2.0%	0.3%	Nil	Nil

Data source: CME Fedwatch

There were 2 critical triggers influencing the CME Fedwatch in the week to June 21, 2024; and all of them were very critical inputs.

• Key FOMC members like Williams and Harker spoke during the week. They expressed concerns over the price levels, although there appears to be consensus that the worst of inflation risk may be over. Fed members continue to be cautious, but optimistic that inflation would eventually come down, making rate cuts a reality in September 2024.
• In the week to June 21, 2024, the API (American Petroleum Institute) reserves saw a drawdown of -2.547 Million barrels. This is lower than expected, but the gist of the story is that oil demand is strong and that is likely to keep crude oil prices at elevated. That is something the Fed has to incorporate into its rate cut decisions.

As of the week to June 21, 2024, the CME Fedwatch was pegging the first rate cut happening in September with the Fed likely to implement 2 rate cuts by December 2024.

CUT TO PRESENT: CME FEDWATCH IN WEEK TO JUNE 28, 2024

The latest week to June 28, 2024 saw the CME Fedwatch continue to factor in 2 rate cut in 2024. Interestingly, the lower GDP growth estimate for Q1 and the lower PCE inflation did not substantially change the probability of rate cuts in 2024.

Fed Meet	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550	550-575
Jul-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	10.3%	89.7%	Nil
Sep-24	Nil	Nil	Nil	Nil	Nil	Nil	6.2%	57.9%	35.9%	Nil
Nov-24	Nil	Nil	Nil	Nil	Nil	2.2%	24.2%	50.2%	23.4%	Nil
Dec-24	Nil	Nil	Nil	Nil	1.6%	18.4%	43.4%	30.5%	6.2%	Nil
Jan-25	Nil	Nil	Nil	0.9%	11.3%	32.8%	36.0%	16.5%	2.6%	Nil
Mar-25	Nil	Nil	0.6%	7.6%	25.1%	34.8%	23.4%	7.5%	0.9%	Nil
Apr-25	Nil	0.3%	3.8%	15.6%	29.6%	29.6%	16.2%	4.5%	0.5%	Nil
Jun-25	0.2%	2.4%	10.8%	23.9%	29.6%	21.6%	9.2%	2.1%	0.2%	Nil
Jul-25	1.1%	5.4%	15.6%	26.0%	26.7%	17.1%	6.6%	1.4%	0.1%	Nil
Sep-25	5.6%	14.1%	24.5%	26.6%	18.5%	8.1%	2.2%	0.3%	Nil	Nil

Data source: CME Fedwatch

There were 3 critical triggers to watch out for in the coming week to June 28, 2024 for CME Fedwatch.

• The third and final estimate of Q1GDP growth was announced on Thursday. At 1.4% in the final estimate, it was 10 bps better than the second estimate, on the back of higher nominal GDP growth. However, there is now a strong case of the US GDP growth aligning with lower 2% inflation and lower consumer spending.
• The PCE inflation figure for May 2024 came in 10 bps lower at 2.6%. While core inflation and food inflation were lower, the pressure of energy inflation continued in May 2024. However, there is now confidence that the last mile inflation can be handled and may actually open the floodgates for cutting rates in September; or even earlier.
• An important data point last week was the outcome of the bank stress tests. As published by the Federal Reserve, the annual bank stress tests show that the large US banks are in a much better position to handle stress compared to last year. However, the challenge for smaller banks may still remain, although it may not be a systemic issue.

The gist of the week data was that the Fed now has enough reasons to go for a rate cut in September 2024, or even attempt a pre-emptive rate cut in July itself.

TRIGGERS FOR CME FEDWATCH: NEXT WEEK TO JULY 05, 2024

The next week will see large parts of the US markets shut for the US Independence Day on July 04, 2024. Here are some key data points for next week.

• Among the FOMC member speak, Jerome Powell and Williams are slated to speak in the coming week. With the data hinting at possible rate cut in September, the markets will be keenly awaiting cues from these Fed speeches. It also remains to be seen if the Fed tone is still hawkish after the recent data flows.
• The minutes of the FOMC meeting held in June will be published on July 03, 2024. It may be recollected that in June, the Fed had updated the long term macroeconomic projections along with the Fed statement. The Fed minutes assume importance as the specific discussion of individual members will now carry a lot of weight.
• On Friday, the non-farm payrolls data and the unemployment rate for June will be put out. In May, the non-farm payrolls had grown by 2,72,000 and is expected to grow at a lower rate of 1,89,000 in June. That would be essential for early rate cuts. Also, the unemployment rate at around 4% would support rate cuts in September.

The big data points in the coming week will, obviously, be the Fed minutes as that will set the tone for how soon the Fed would be willing to cut rates.

CME FEDWATCH – COULD BE MORE AGGRESSIVE IN 2025

Did the PCE inflation and the GDP data bring about a drastic change in the rate cut expectations in this week? Not exactly, because the probabilities are almost constant as the previous week and appear to have stabilized. Probably, the movement will come only after the first rate cut is implemented by the Fed. For now, the probability charts don’t seem to indicate any likelihood, but there is an outside possibility that the Fed may cut rates pre-emptively on July 31, 2024 itself, rather than wait till September FOMC meet.

• With rate hikes virtually ruled out for now, we will first focus on rate cut probability in 2024. Let us first look at the rate cut possibilities in 2024. Currently, the CME Fedwatch has assigned a 64% probability that the first rate cut will happen in September; almost same as last week. For now, July rate cut has a probability of just about 10%. However, by December 2024, the CME Fedwatch is pencilling in a 63.3% probability of 2 rate cuts.
• What about the CME Fedwatch expectations stack for 2025? By July 2025, the CME Fedwatch is factoring in an 74.8% probability of 4 rate cuts, which is quite aggressive. In addition, the CME Fedwatch is also assigning a probability of 70.9% probability of 5 rate cuts by September 2025. However, these probabilities are likely to evolve more realistically once the Fed embarks on its first rate cut this year.

The real question is not whether the Fed will cut rates, but whether it can afford to play dog-in-the-manger. For now, it can, but the Fed may not want to play that game beyond September. The Million dollar question is whether the Fed would really venture out and take up pre-emptive rate cuts in the July 31, 2024 Fed meet itself. That would be a surprise, but cannot be ruled out.