Weekly Musings – How CME Fedwatch changed for the week to July 21, 2023

22 Jul 2023 , 08:05 PM

As the US Federal Reserve prepares for the next Fed meeting on July 26, 2023, there is a very quiet change that has taken place in the way the markets have interpreted the signals coming from the Fed. With the June Consumer inflation in the US coming in sharply lower at 3%, there is a sudden bout of dovishness that has overtaken the CME Fedwatch. The shift has been triggered by two factors. 

Firstly, the sharp fall in consumer inflation by 190 basis points in just two months gives the US Fed the confidence that inflation is now firmly on the path to its target of 2%. Secondly, if the Fed calls a top to the Fed rates now, then it can come out all guns blazing. In the last 15 months, the Fed would have not only managed to contain inflation to its 2% target but also done it without triggering recessionary conditions in the US. In short, it would have been a much needed soft landing for the US economy.

WILL THE FED CALL A TOP ON RATES IN JULY?

So, what is this decision that the Fed is expected to take? Most of the US economists are now pencilling that July could see a rate hike of 25 bps but that would also be the last rate hike in this round. It has already been the most aggressive bout of rate hikes in the last 40 years and the Fed is keen to avoid any negative repercussions. Between March 2022 and May 2023, the Fed hiked rates by a total of 500 basis points from the range of 0.00%-0.25% to the range of 5.00%-5.25%. 

If the Fed calls it a day after another 25 bps rate hike in July, it would have hiked rates by a full 525 basis points. More importantly, the GDP data is still robust, consumer demand is strong and labour market is still undersupplied, keeping wages high. This combination has ensured that growth has not been hit despite the aggressive rate hike pitch. However, anything that is too good to be true is normally untrue and the Fed would not want to test its chances for too long. July may be the right time for the Fed to call off its hawkish stance.

RECAP – CME  FEDWATCH FOR THE WEEK ENDED JUNE 14, 2023

Here is a quick recap of how the CME Fedwatch looked like for the previous week, before the above data points on the Fed meet and inflation were factored in.

Fed Meet	375-400	400-425	425-450	450- 475	475- 500	500-525	525-550	550-575	575-600
Jul-23	Nil	Nil	Nil	Nil	Nil	7.0%	93.0%	Nil	Nil
Sep-23	Nil	Nil	Nil	Nil	Nil	6.2%	82.7%	11.2%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	2.5%	37.8%	53.1%	6.5%
Dec-23	Nil	Nil	Nil	Nil	1.9%	28.2%	49.0%	19.2%	1.8%
Jan-24	Nil	Nil	Nil	1.0%	16.6%	39.8%	32.3%	9.5%	0.8%
Mar-24	Nil	Nil	0.4%	6.6%	24.9%	37.1%	24.1%	6.3%	0.5%
May-24	Nil	1.0%	8.4%	26.1%	35.8%	22.4%	5.8%	0.5%	Nil
Jun-24	0.6%	5.1%	18.2%	31.5%	28.4%	13.2%	2.8%	0.2%	Nil
Jul-24	5.0%	16.5%	29.7%	18.8%	15.2%	4.2%	0.5%	Nil	Nil

Data source: CME Fedwatch

The week prior to the latest week did not have too many data points but was still critical since the US consumer inflation was announced in that week. At 3%, the consumer inflation had bettered all expectations. It was now just 100 bps away from its long term target of 2% and the Fed could actually take the risk of allowing the lag effect of past rate hikes to play out on inflation. Till the previous week, most of the Fed members in their routine speeches have been hinting at 2 to 3 rate hikes. Even governor Chris Waller in his speech underlined clearly that there would at least be two more rate hikes of 25 bps each and the estimate was that the peak rate for the Fed rate would be 6%. 

WHAT WE READ FROM THE CME FEDWATCH IN THE WEEK TO JULY 21, 2023

The week to July 21, 2023 did not have too many critical data points but it happened to be the most critical week in terms of signals coming from the CME Fedwatch. When the US inflation was announced at 3% in the previous week, there was a leftward shift in the Fed hike probabilities but the peak rate assumptions still hovered around 6%. It is in the latest week that this peak rate assumption has suddenly changed and the CME Fedwatch is now looking at a more certain and narrow range wherein the markets are betting on Fed rates peaking earlier and subsequent rate cuts in 2024 being deeper.

Fed Meet	375-400	400-425	425-450	450- 475	475- 500	500-525	525-550	550-575	575-600
Jul-23	Nil	Nil	Nil	Nil	Nil	0.2%	99.8%	Nil	Nil
Sep-23	Nil	Nil	Nil	Nil	Nil	0.2%	83.9%	16.0%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	0.1%	68.6%	28.4%	2.9%
Dec-23	Nil	Nil	Nil	Nil	Nil	8.9%	65.3%	23.6%	2.2%
Jan-24	Nil	Nil	Nil	Nil	3.2%	29.3%	50.2%	15.9%	1.4%
Mar-24	Nil	Nil	Nil	2.1%	17.7%	40.2%	31.0%	8.3%	0.7%
May-24	Nil	Nil	2.0%	16.9%	38.5%	31.6%	9.8%	1.2%	Nil
Jun-24	Nil	0.9%	9.0%	27.0%	35.2%	21.3%	5.8%	0.7%	Nil
Jul-24	0.60%	7.0%	23.2%	33.9%	24.5%	8.9%	1.7%	0.1%	Nil

Data source: CME Fedwatch

Let us now turn to the most important shift in the current week and that is on three fronts. Firstly, the assumption that the market is veering towards is that the Fed will stick to its rate hike in the July 26, 2023 meeting but will call off further rate hikes after that. In short, the Fed rates would effectively peak at the range of 5.25%-5.50% range. The Fed would now be relatively confident that the lag effect should take the inflation lower while cautious demand would do the rest of the job in keeping prices low. 

That would mean the Fed outlook and the language of the Fed in July 2023 would clearly hint at an end of rate hikes with a clear indication that further rate hikes were ruled out except in an emergency. Of course, the Fed still has the leeway of keeping the rates at current levels for much longer and that is something the Fed is very likely to do. However, hawkishness may very well end in the July 26, 2023 policy of the FOMC (Federal Open Markets Committee).

UNDERSTANDING SHIFTS IN THE CME FEDWATCH

How exactly has the CME Fedwatch shifted in the last one week as the markets have tried to seriously absorb the message of rates peaking in the month of July. What the probabilities indicate is that a 25 bps rate hike in July is almost inevitable. However, the Fed would then venture out and give up on its hawkish stance. At the current rate of interest, the Fed is already more than 200 bps above the neutral rates. Ideally, each rate hike should be hitting the growth in a palpable manner. However, that is not happening only because labour data is still strong and hence consumer demand has stayed robust. Fed is likely to take its own time on when to start cutting rates. While rate cuts are expected to start in 2024, the Fed has the leeway to delay rate cuts. Going ahead, the CME Fedwatch indicates that the Fed may rely more on prolonging elevated rates than hiking rates further. That is the takeaway.

TRIGGERS FOR CME FEDWATCH TO TRACK IN COMING WEEK

The coming week has 5 important data points which will have a bearing on the CME Fedwatch. Here is a quick look at the 5 triggers for the coming week.

1. The big trigger will be the FOMC meeting scheduled on July 26, 2023. A rate hike of 25 bps is almost a fait accompli, but that is not the focus. There is a strong expectation that after the latest rate hike of 25 bps, the Fed may call an end to hawkishness. If that does happen, it would be big news for the CME Fedwatch.

    

2. The second big trigger will be the crude inventories in the US reported by the American Petroleum Institute (API). Why does this matter. In the last few weeks, crude prices in the world have gone up due to supply cuts by OPEC and sharp fall in US inventories. Spike in crude will mean higher inflation but will also mean growth is reviving.

    

3. The all important PCE (personal consumption expenditure) inflation will be reported on July 28, 2023 and that will set the tone for Fed action. PCE inflation is expected to fall in tandem with consumer inflation from 3.8% to around 3.2%, but the real focus would be on the core PCE inflation which had been elevated at 4.6% levels.

    

4. An important part of the Fed hawkish has been the tapering of the fed balance sheet, apart from rate hikes. On July 27, 2023, the Fed will announce the Fed Balance sheet. It is expected to fall from the last $8.27 trillion to below the $8 trillion. That will be an added incentive for the Fed to go easy on rates.

    

5. Above all, Thursday July 27, 2023 will also see the first advance estimate of Q2 GDP being announced. It is generally expected to taper from 2% in Q1 to 1.8% in Q2. However, any number better that would be a signal that growth still remains robust and would also induce the Fed to withdraw hawkishness before it is too late.

In short, this will be a truly data heavy week for the CME Fedwatch and we could see the Fedwatch change its colours by the end of the week.

WHAT IS IT THAT INDIA MUST WATCH OUT FOR?

From India’s perspective, there will be a close watch on the shifts in the CME Fedwatch as it gives the clearest and most market friendly picture of which way the monetary policy winds are blowing. From being quite emphatic about two more rate hikes of 25 bps each in 2023, the Fed is expected to shift to just one rate hikes in this year. India would be closely watching the July 26, 2023 policy of the US Fed. July rate hike of 25 bps is already in the price and that may not be too relevant. India would be pleased to see the Fed calling a top on rates after the July hike as it sharply reduces the risk of monetary divergence.

India is up against 2 additional challenges on the macro front. Firstly, even as US inflation in June fell from 4% to 3%, India consumer inflation bounced from 4.25% to 4.81%. Therefore, the gap advantage has vanished. If the Fed calls a top on rates in the July policy, then the RBI would not be overly worried about having second thoughts about its monetary stance. Secondly, India has a genuine concern on food inflation, although it looks like a cyclical issue due to erratic rains. The best bet for India at this stage would be if the Fed hikes rates by 25 bps in July and also indicates a top. That would be more valuable for India than just a pause.