Weekly Musings – CME Fedwatch change for week to November 03, 2023

6 Nov 2023 , 09:23 AM

FED HOLDS RATES, HARPS ON LONGER PAUSE

The previous week was all about the Fed policy statement issued late on November 01, 2023. Along expected lines, the Fed maintained status quo on rates and kept them in the range of 5.25% to 5.50%. While the Fed maintained its stance that it would hike rates if inflation went out of control, the markets are interpreting it as a signal that the rate hikes may be done and dusted. That is not all. As we shall see later, the CME Fedwatch is also predicting that the Fed will go aggressive cutting rates in the coming year, something the Fed has refused to give any commitment on. 

The Fed policy got mixed reactions from the experts. One section was of the view that the Fed had been pragmatic considering that spending was already being impacted and the tightness in the job market was moderating. They expected the Fed to change stance from hawkish to moderate and even embark on a series of rate cuts next year. However, the more conservative segments are of the view that with Fed holding rates for 3 out of the last 4 meetings, it may have an incentive to front-end rate hikes, in one last-ditch effort to push down inflation closer to 2%. For now, there is not clarity, but one must remember that the Fed takes its communication very seriously and rarely digresses from its guidance, unless the economic conditions desperately warrant such a shift.

ACTION WAS IN BOND YIELDS AND DOLLAR INDEX (DXY)

In the US market, there are two classic proxies for the Fed guidance, apart from, the CME Fedwatch. They are the 10-year bond yields and the Dollar Index (DXY). Let us look at the US 10 year bond yields first. After touching a high of 5% in previous weeks, the 10 year US bond yields fell sharply to 4.58% during the week. This was after the Fed announced holding status quo on rates. However, the markets have a different take. They feel, the bond yield movement is less about Fed guidance and more about other factors. In recent weeks, the spike in bond yields and the recent fall has been driven more by bond buying / bond selling as well as the yield cover shifts by bond traders, where they keep readjusting the yields across different durations. Long term yields are just doing catch up with shorter term  yields.

The other big indicator this week was the dollar index (DXY). The dollar index is a barometer of dollar strength and is measured against a basket of hard currencies globally including the Pound, Euro, Yen, and Yuan. The dollar index had crossed 107 just a couple of weeks back. In the latest week, after the Fed policy statement, the US dollar index fell sharply from 106.88 levels to 105.02 levels. The dollar index and the 10 year bond yields normally move in tandem since higher bond yields, make dollar debt attractive and attracts capital flows, thus strengthening the dollar.

RECAP – CME  FEDWATCH FOR THE WEEK ENDED OCTOBER 27, 2023

Here is a quick recap of how the CME Fedwatch looked like for the previous week to October 27, 2023, before the current week’s data points were factored in.

Fed Meet	375-400	400-425	425-450	450- 475	475- 500	500-525	525-550	550-575	575-600
Nov-23	Nil	Nil	Nil	Nil	Nil	0.1%	99.9%	Nil	Nil
Dec-23	Nil	Nil	Nil	Nil	Nil	0.1%	80.1%	19.8%	Nil
Jan-24	Nil	Nil	Nil	Nil	Nil	0.1%	71.8%	26.0%	2.0%
Mar-24	Nil	Nil	Nil	Nil	Nil	13.0%	63.6%	21.7%	1.7%
May-24	Nil	Nil	Nil	Nil	5.1%	32.8%	47.2%	13.9%	1.0%
Jun-24	Nil	Nil	Nil	2.5%	18.6%	39.8%	31.0%	7.6%	0.5%
Jul-24	Nil	Nil	1.6%	13.1%	32.6%	34.0%	15.5%	2.9%	0.2%
Sep-24	Nil	0.9%	8.1%	24.1%	33.4%	23.6%	8.5%	1.4%	0.1%
Nov-24	0.3%	3.6%	14.0%	27.5%	29.7%	18.0%	5.8%	0.9%	Nil
Dec-24	2.3%	9.3%	21.4%	28.7%	23.3%	11.3%	3.1%	0.4%	Nil

Data source: CME Fedwatch

There were 3 major factors that influenced the CME Fedwatch in the week to October 27, 2023. Two of them were about actual data flows, and the third was about a mix of macro indicators.

• On October 26, 2023, the Bureau of Economic Analysis (BEA) published the first advance estimate of Q3 GDP. There will also be the second estimate and the final estimate published towards the end of November and December respectively. The quarterly GDP growth spiked from 2.1% in Q2 to 4.9% in Q3. The Q3 GDP growth was not only better than the Q2 growth, but also 80 bps better than the Reuters estimate. That is a strong case of a more cautiously hawkish policy by the Fed. The spike in GDP was driven by higher private spending, so it means rate hikes would be less effective in dealing with inflation. 

   

• The second big data flow this week was the PCE (private consumption expenditure) inflation on Friday October 27, 2023. The Fed uses the PCE headline inflation and the PCE core inflation as the triggers for monetary policy. The headline yoy PCE inflation was flat at 3.4%; where it has remained static for the last 3 months. The problem is that the Fed is still 140 bps away from the 2% target and the traction is far from encouraging. PCE core inflation showed high frequency pressure at 0.4% and that could largely be about the oil price impact. 

   

• During the week to October 27, 2023, the US bond yields continued to hover close to the 5% mark and the dollar index remained biased towards the 106-107 range. These are signals that more rate hikes could be in the offing, but they are also signs of yields being impacted by bond price pressures and the impact of yield curve normalization as long duration bonds are gaining premium over shorter tenure bonds. 

The Fed has been going steady on bond book unwinding and in the last 15 months about $1.1 trillion has been unwound. Clearly, the Fed does not want to create any liquidity shock, especially after the mini-banking crisis that the US faced in the early part of 2023. The Fed will stick to its strategy of holding rates higher for longer and avoid further rate hikes at this point of time. The CME Fedwatch appears to have a diametrically opposite point of view on rate cuts in 2024, but that is a separate discussion for now.

CME FEDWATCH IN THE LATEST WEEK TO NOVEMBER 03, 2023

The latest week to November 03, 2023 saw CME Fedwatch get back to its decisive ways. CME Fedwatch is hinting at a virtual end of rate hikes in the US in the current round and aggressive rate cuts in the next year.

Fed Meet	375-400	400-425	425-450	450- 475	475- 500	500-525	525-550	550-575	575-600
Dec-23	Nil	Nil	Nil	Nil	Nil	Nil	95.2%	4.8%	Nil
Jan-24	Nil	Nil	Nil	Nil	Nil	Nil	91.2%	8.6%	0.2%
Mar-24	Nil	Nil	Nil	Nil	Nil	25.5%	68.%	6.2%	0.1%
May-24	Nil	Nil	Nil	Nil	14.6%	49.8%	32.8%	2.8%	0.1%
Jun-24	Nil	Nil	Nil	9.4%	37.4%	38.8%	13.4%	1.0%	Nil
Jul-24	Nil	Nil	6.6%	29.1%	38.4%	20.9%	4.7%	0.3%	Nil
Sep-24	Nil	4.6%	22.3%	35.6%	26.2%	9.6%	1.6%	0.%	Nil
Nov-24	2.5%	14.3%	29.5%	30.5%	17.1%	5.2%	0.8%	Nil	Nil
Dec-24	11.9%	24.3%	31.1%	21.7%	9.3%	2.3%	0.3%	Nil	Nil

Data source: CME Fedwatch

There were several triggers impacting the CME Fedwatch in the current week. Here are 2 such factors that had a bearing in the week to November 03, 2023. 

• The first big event was the Fed meeting that commenced on October 31, 2023 and culminated with the Fed statement on November 01, 2023. The Fed held rates at the current range of 5.25% to 5.50%, and it looks quite likely that the Fed may stick to its “Higher for Longer” approach. For now, it does not have any reason to hike rates, although the static PCE inflation at 3.4% and the robust GDP growth at 4.9% may be a concern. The Fed statement was largely uneventful and along expected lines.

   

• The second key data point was the sharp fall in the US 10-year bond yields as well as the sharp fall in the dollar index. Both were outcomes of the Fed statement, but it was these variables that changed the tone of the CME Fedwatch.

This week saw the CME Fedwatch diverging majorly from the Fed point of view. We will deal with it in detail towards the end of this note.

TRIGGERS FOR CME FEDWATCH TO TRACK IN COMING WEEK

There are several triggers for the coming week, which is likely to impact the CME Fedwatch. Here are 3 such factors to watch in the coming week to November 10, 2023. 

• There are important speeches by Powell, Waller, and Williams. These speeches assume importance in the light of the wide divergence between what the Fed has spoken and how the CME Fedwatch has interpreted it. Markets will eventually take the speeches as the final word on the subject. 

   

• The trajectory of the US 10-year bond yields and the dollar index will be closely watched. In the past, the bond yields and the dollar index have been fairly accurate and reliable lead indicators of which way the Fed trajectory is headed.

On the CME Fedwatch front, the big story this time is not the probabilities but about how the dichotomy between the Fed statement and the CME Fedwatch is back. Here is what it means.

CME FEDWATCH VS FED STANCE: IT IS DICHOTOMY ONCE AGAIN

Dichotomies between the Fed stance and the CME Fedwatch are quite common. However, in the last few months, there have not been instances of such dichotomies as the Fedwatch has broadly mirrored the Fed stance. However, this time the dichotomy is quite evident. Here are 3 instances.

• The Fed, on its part, was quite emphatic in its statement that it would not hesitate to hike rates further if need be. However, the CME Fedwatch has almost ruled out any rate hike. If you look at the probability of even a 25 bps rate hikes in the next one year, it is still in single digits. However, Fed has even suggested that it may go beyond one rate hike to ensure inflation is quickly brought to the target of 2%. 

   

• The bigger dichotomy is on the rate cut front. The Fed on its part has ruled out any discussion on rate cuts for the time being. However, the CME Fedwatch is pegging as many as 5 to 6 rate cuts in the next one year. The Fed had suggested a best case scenario of just about 2 rate cuts by December 2024.

   

• The third dichotomy is on the assumption of terminal rates on the upside and guidance on the downside. On the upside, the Fed has not given any figure, but had hinted at 6% being the terminal rate on the upside. However, on the downside, the Fed does not see rates going below 5%, even by the end of 2024. On the other hand, the CME Fedwatch has already assumed the end of rate hikes at the current level. In addition, CME Fedwatch is pegging rates being cut to as low as 4% to 4.25% by end of 2024.

The dichotomies are huge and, in the past, it is the CME Fedwatch that eventually gravitated towards the Fed view. It remains to be seen, which way the wind blows this time around.