Weekly Musings – CME Fedwatch change for week to September 01, 2023

4 Sep 2023 , 06:42 AM

In the last few months, we have not seen the CME Fedwatch diverging too much from the stated text of the Fed speech. After a fairly long time, the CME Fedwatch has once again shown divergence from the Fed perspective, but we will back to that later. The focus is on two major announcements during the week. In the previous week, Jerome Powell set the tone for US monetary policy when he spoke at the Jackson Hole symposium. The message from Powell was crystal clear. The Fed shall not relent on inflation control, whatever the costs. What he meant was that one or two rate hikes were extremely like before the end of 2023. Although the Fed did hint at a pause in September, it was clear that it would mean certain rate hikes in November and possibly in December too.

At Jackson Hole, Powell played his cards pretty close to his chest. There was little mention of any time frame or of the terminal rates for the Fed Funds benchmark. The only thing Powell said what that the Fed would continue to be hawkish till the time the monster of consumer inflation (or more appropriately PCE inflation) was brought down to 2% with PCE core inflation following suit. For the current week, the major data triggers came from the second estimate of June quarter GDP estimate for the US economy and the PCE inflation for July 2023. The second estimate for US GDP came in 30 bps lower than the first estimate  while the PCE inflation came in 30 bps higher for July 2023 compared to June 2023.

CME FEDWATCH AGAIN DIVERGES FROM THE FED MONETARY GUIDANCE

With Fed rates in the range of 5.25% to 5.50%, it is always going to be a tough call for the Fed. They do not have too much of room to hike rates, yet they need to contain consumer inflation and also inflation expectations. The divergence stems from the interpretation of the two critical data points during the current week. The second estimate for Q2 GDP was cut by 30 bps from 2.4% to 2.1%. At the same time, the PCE (personal consumption expenditure) inflation has picked up by 30 bps from 3.0% in June 2023 to 3.3% in July 2023. Even the core PCE inflation has bounced from 4.1% to 4.2%. This spike in inflation came due to a sharp spike in services inflation, even as good inflation continued to remain in the negative. Services inflation spiked to above 5% in July 2023. Now for the interpretation!

The Fed has interpreted it more as a data anomaly and it does not plan too much of a shift in its hawkish stance. The Fed line of argument is that rising rates have not had any significant impact on the GDP growth numbers and hence the risk of hard landing may have been overstated. The Fed is confident that the US Federal Reserve should be able to impose higher rates of interest, even as the economy moves towards a soft landing. However, the week saw major dovish shift in the CME Fedwatch with market analysts suggesting that the Fed may have to call off rate hikes to protect GDP growth. The CME Fedwatch, therefore, is not only betting on just one more rate hike at the maximum, but it is also betting that rate cuts could be much quicker and deeper from current levels. It must be remembered that the Fed takes it communication seriously due to its implications for inflation expectations. Hence, the Fed is unlikely to diverge too much from its stated stance. In the past, whenever the CME Fedwatch diverged widely from the view of the Fed, it had been forced to modify its view. It remains to be seen, what is the outcome this time around?

RECAP – CME  FEDWATCH FOR THE WEEK ENDED AUGUST 25, 2023

Here is a quick recap of how the CME Fedwatch looked like for the previous week to August 25, 2023, before the above 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
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	80.0%	20.0%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	44.5%	46.7%	8.9%
Dec-23	Nil	Nil	Nil	Nil	Nil	1.8%	44.5%	45.2%	8.5%
Jan-24	Nil	Nil	Nil	Nil	0.3%	8.0%	44.6%	39.9%	7.3%
Mar-24	Nil	Nil	Nil	0.1%	2.6%	19%	43.2%	30.1%	5.1%
May-24	Nil	Nil	Nil	1.2%	10.1%	30.1%	37.2%	18.7%	2.8%
Jun-24	Nil	0.3%	0.7%	6.0%	20.3%	33.9%	27.2%	10.1%	1.3%
Jul-24	Nil	0.5%	4.3%	16.1%	29.8%	29.3%	15.5%	4.1%	0.4%
Sep-24	0.4%	3.5%	13.5%	26.8%	29.4%	18.6%	6.6%	1.2%	0.1%

Data source: CME Fedwatch

Let us quickly recap the 3 factors that had an impact on the CME Fedwatch during the week to August 25, 2023. This will serve as the backdrop for our understand of the movement in the CME Fedwatch in the week to September 01, 2023.

• Let us start with the relatively hawkish tone of the Michelle Bowman speech in that week. Bowman, a known hawk, had then reiterated the possibility of two more rate hikes of 25 bps as a very likely scenario. While the Fed chair also happens to be veering around to that view, the CME Fedwatch thinking is in contrast.

   

• The Fed had cut its bond book aggressively by close to $1 trillion, against its original bond book size of $9 trillion. That will add to the tightness in the market and may reduce the need for aggressive rate hikes, but we have to wait and watch.

   

• The highlight of the previous week was the Jerome Powell address at Jackson Hole. Powell had underscored the need to remain hawkish till inflation moved to 2%. Of course, his famous debate on “doing too much versus doing too little” had left markets relatively confused.

In a sense, the week to August 25, 2023 had given the first credible indications that the terminal Fed rates could possibly move beyond the 6%. For now, it is data, as it comes! 

HOW CME FEDWATCH SHIFTED IN THE WEEK TO SEPTEMBER 01, 2023

The week to September 01, 2023 saw a distinct shift in the probabilities to the left (more dovish). The probability of rates now going up to 6% is now almost nil, while reversal from current rates is expected to happen by first quarter of 2024. CME Fedwatch is also factoring in deeper cuts to rates and at a quicker pace. This is in conflict with the indications that the Fed chair and other Fed members have been consistently giving out.

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	94.0%	6.0%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	64.6%	33.5%	1.9%
Dec-23	Nil	Nil	Nil	Nil	Nil	5.6%	61.9%	30.8%	1.7%
Jan-24	Nil	Nil	Nil	Nil	1.1%	17.2%	55.4%	24.8%	1.4%
Mar-24	Nil	Nil	Nil	0.5%	8.2%	34.1%	42.0%	14.5%	0.8%
May-24	Nil	Nil	0.3%	4.6%	21.9%	38.3%	27.4%	7.2%	0.4%
Jun-24	Nil	0.2%	3.1%	15.8%	32.5%	31.2%	14.3%	2.8%	0.1%
Jul-24	0.1%	2.2%	12.0%	27.5%	31.6%	19.4%	6.1%	0.9%	Nil
Sep-24	1.9%	10.1%	24.4%	30.8%	21.8%	8.8%	2.0%	0.2%	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 September 01, 2023.

• Firstly, the PCE inflation for July 2023 came in 30 bps higher at 3.3% and the core PCE inflation was 10 bps higher at 4.2%. Most of the pressure came from fuel inflation but at a more basic level, it was services that was driving the PCE inflation higher even as the inflation on durable and non-durable goods stayed negative. Rate hikes seem to be on

   

• On the subject of energy inflation, the US API crude inventories were supposed to fall by 3.3 million barrels for the week but instead fell by 10.6 million barrels. This is likely to put further pressure on the Brent crude prices, which has already touched $88/bbl.

   

• Lastly, the big news was on the GDP front, with second estimate for Q2-2023 being cut by 30 bps from 2.4% to 2.1%. While this may not seriously impact the hawkish stance of the Fed, it does raise some questions about whether the Fed can actually manage a soft landing, as they have been persistently claiming.

When it comes to CME Fedwatch, the week to September 01, 2023 saw the markets lower its peak rate assumptions from 6.00% to 5.75%. CME Fedwatch is also expecting deeper rate cuts and for a longer period.

TRIGGERS FOR CME FEDWATCH TO TRACK IN COMING WEEK

The coming week to September 08, 2023 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. API stocks are again expected to fall in double digit million barrels in the coming week and that could push Brent Crude above $90/bbl. The data would be crucial and it will be announced on Wednesday, September 06, 2023. It could push up inflation overall.

    

2. Among FOMC members, Williams and Bowman are expected to speak during the week. The tonality from both is expected to remain hawkish and it remains to be seen how the CME Fedwatch changes its stance based on the Fed speak inputs coming in next week.

    

3. The composite PMI is expected to be announced in the coming week. This is a high frequency measure of the short term pressures on growth. Both the services PMI and the compositive PMI are expected to witness pressure this week. It remains to be seen how the Fed fine tunes its soft landing interpretation after this data flow.

For now, the CME Fedwatch is diverging from the stated Fed view. It remains to be seen how long this divergence is sustained.

INDIA WILL  BE LOOKING FOR SOME ANSWERS THIS WEEK

The RBI would keep a close watch on the shifts in the CME Fedwatch as will the Indian financial markets. CME Fedwatch captures a market perspective of which way the monetary winds are blowing. For India, the 30 bps higher US PCE inflation and 30 bps lower GDP reading, poses some very sticky and delicate questions. For now, the RBI has not hiked rates despite inflation coming in at 7.44% in July. The RBI has to quickly take a call on rate hikes; the question being whether to wait till October or do it earlier? RBI stays non-committal, but that is the million dollar question.

From a policy perspective, it is clear that the primary focus of the Fed would be to get inflation under control and then worry about GDP and consumer spending. After all, when inflation expectations are being managed, that is not much more than people can generally ask for. India would be happy with some degree of monetary convergence as it reduces the risks of financial market volatility. However, that does not appear to be on the agenda for now as most central banks prefer to chart their own course. India FPI flows are already hit and India has some hard questions to answer on inflation already.