Weekly Musings – How CME Fedwatch changed for the week to July 28, 2023

31 Jul 2023 , 09:45 AM

It was a hectic week for the US markets and the CME Fedwatch with 3 major data points coming out in the week to July 28, 2023 on 3 successive days. For instance, the Fed policy announcement came in on July 26, 2023, wherein the Fed hiked rates by 25 bps as was already expected. Secondly, on July 27, 2023, the first advance estimate of Q2-2023 GDP was put out by the Bureau of Economic Analysis (BEA) at 2.4%. Finally, on July 28, 2023, the PCE inflation for the month of June came in sharply lower at 3%. How did these 3 factors impact the colour of the CME Fedwatch?

In fact, the impact was not too significant if you compare the close of the current week with the close of the previous week. That is because all the 3 data points were broadly as per expectations. The Fed policy was expected to hike rates and give hints of topping out. It directly executed the former and gave adequate hints of the latter. The GDP was expected to better the street estimates, although the extent of outperformance was higher than was expected. Largely, the PCE inflation was also expected to fall, although the magnitude of the fall was bigger than anticipated. The only change that has come about in this week is that the markets are expecting the Fed to hold out longer at the current rate levels. In fact, now the expectation is that rates may fall by just about 50 bps by middle of next year.

A MORE BENIGN ALTERNATIVE TO RATE HIKES

In the July meeting of the Fed, the rates were once again hiked by 25 bps. That was on the cards and that has now taken the Fed rates a full 525 bps higher from the range of 0.00%-0.25% to the current range of 5.25%-5.50%. the rate hikes started in March 2022, so the total of 11 rate hikes adding up to 525 basis points has happened across 16 months. This is one of the quickest bout of rate hikes by the US Fed since hiked rates so aggressively in the early 1980s, during the famous Volcker era. Also, this rate hike in July 2023, takes the Fed rates to the highest level since 2001, which is a good 22-year record.

One thing the Fed did hint in the policy statement was that rather than hiking rates further, it may prefer to prolong the pause at a higher level. That is now being reflected in the shift in rate hike expectations. The Fed is looking at 3 alternatives to more rate hikes. Firstly, bank credit to consumers has already tightened after the Silicon Valley Bank and the Signature Bank implosion. Secondly, the Fed has also been reducing its asset book and has now cut it from $9.1 trillion down to $8.3 trillion over the last 1 year. That has also tightened liquidity. The third instrument the Fed plans to use is to lengthen the period of pausing at higher levels as an alternative to hiking rates. The Fed believes that these 3 combined would work effectively. That eliminates the need for rate hikes as of now.

RECAP – CME  FEDWATCH FOR THE WEEK ENDED JUNE 21, 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	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

It may be noted that while the actual data points on Fed rates, PCE inflation and GDP were announced during the current week, the expectations had been set in the previous week itself. Hence most of the parameters had been factored into the CME Fedwatch in the previous week itself, which explains why the overall structure of the CME Fedwatch probabilities have remained the same at a broad level. 

WHAT WE READ FROM THE CME FEDWATCH IN THE WEEK TO JULY 28, 2023

The week to July 28, 2023 had 3 critical data points and each had an impact on the CME Fedwatch during the week. However, most of the changes had been broadly factored into the CME Fedwatch in the previous week itself and the expectations had been broadly in line with what actually transpired. The table below captures the CME Fedwatch probabilities at the close of the week to July 28, 2023.

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	0.2%	80.0%	20.0%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	0.1%	67.1%	29.7%	3.2%
Dec-23	Nil	Nil	Nil	Nil	Nil	8.9%	62.1%	26.2%	2.8%
Jan-24	Nil	Nil	Nil	Nil	2.4%	23.2%	52.5%	19.9%	2.0%
Mar-24	Nil	Nil	Nil	1.0%	11.1%	35.5%	38.8%	12.4%	1.2%
May-24	Nil	Nil	0.8%	8.9%	30.2%	38.1%	18.2%	3.6%	0.3%
Jun-24	Nil	0.3%	4.0%	17.3%	33.3%	30.2%	12.4%	2.3%	0.2%
Jul-24	0.20%	2.9%	13.4%	28.6%	31.1%	17.7%	5.3%	0.8%	Nil
Sep-24	2.5%	11.1%	25.2%	30.6%	20.6%	8.0%	1.8%	0.2%	Nil

Data source: CME Fedwatch

Let us now turn to the 3 factors that had an impact on the CME Fedwatch during the current week in terms of policy announcements.

1. The first big data point was the Fed statement post the July 26, 2023 policy meet. Along expected lines, the Fed hiked rates by 25 bps but that was expected. What was being looked forward to was the nuances of the language of the Fed. Here, the Fed avoided any future guidance on rates but insisted that it would be purely data driven. However, the Fed did emphasize on holding the rates at higher levels for longer as an alternative to hiking rates. That is positive as it means that the Fed may be reconciled to being done with rate hikes and future action may be more by prolonging the pause on rates.

    

2. The second major data point was the GDP first advance estimate for the second quarter ended June 2023. This is the advance estimates and there will be 2 more estimates. However, at 2.4%, the GDP was not only 40 bps above the Q1 GDP but also well above the street estimates, which had pegged GDP growth in the range of 1.8% to 2.0% for Q2. However, while the real GDP growth was higher, the nominal GDP growth was lower in the second quarter with the advantage coming from lower inflation. This could have a dual interpretation for the Fed.

    

3. Finally, the all-important PCE inflation came in at 3.0% with the core PCE inflation coming in at 4.0%. This is in line with the Fed target of 2.0% and it can now afford to go slow on rate hikes and allow the lag effect of rate hikes to do the job.

The big takeaway for the week was that, instead of hiking rates further, the Fed may look to prolong the pause on rates at higher levels. This shift in thinking is reflected in the probabilities as the markets are now pencilling in just 50 bps lower rates by the middle of 2024.

TRIGGERS FOR CME FEDWATCH TO TRACK IN COMING WEEK

The coming week has 4 important data points which will have a bearing on the CME Fedwatch. Here is a quick look at the 4 triggers for the coming week.

1. With the Fed meeting, the GDP announcement and the PCE inflation being completed last week, there are no major triggers. However, this week, one will have to watch for two things. Firstly, how the markets react to the lower than expected PCE inflation will be of interest. Secondly, the markets will be keen to understand how the markets will interpret future Fed action in the light of the GDP and the PCE inflation data.

    

2. The second trigger will be the crude inventories reported by the American Petroleum Institute (API). In the last few weeks, crude prices have gone up sharply to nearly $85/bbl in the Brent Market due to supply cuts by OPEC and sharp fall in US inventories. Spike in crude will mean higher inflation and that could change calculations.

    

3. An important part of Fed hawkishness has been the tapering of the Fed balance sheet. The latest Fed Balance sheet data indicates that in the last 1 year the Fed bond book has fallen from $9.1 trillion to $8.3 trillion and is poised to fall below $8 trillion. That will be an added incentive for the Fed to go easy on rates.

    

4. The week will also see the jobs data, which has been hovering in the range of 3.5% to 3.6% unemployment levels. That is very close to being called full employment. In fact, the data is critical since controlling inflation without increasing joblessness has been one of the avowed goals of the Fed.

In short, this will not be so much a week of data as it will be a week of reaction to data. The coming week should provide greater clarity on the interpretation of data points.

WHAT SHOULD INDIA REALLY WATCH OUT FOR?

Indian markets and also the RBI will keep a close watch on the shifts in the CME Fedwatch as it gives the clearest and most market-oriented picture of which way the monetary policy winds are blowing. Fed language has shifted from one more certain hike to prolonging the pause. That is positive for India as it does not have to worry too much about monetary divergence with the US macro situation. India would be more than happy to see the Fed calling a top on rates after the July hike as it sharply reduces the risk of monetary divergence. To be candid, the Fed has almost done that.

The challenges for India are more on the domestic front. Firstly, 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 more or less vanished. However, with the Fed almost calling a top on rates in the July policy, RBI would not be overly worried 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 was that the Fed hikes rates by 25 bps in July and also calls a top. That may not have happened explicitly but is evident if you read between the lines of the Fed statement. Of course, the data flows have more than corroborated that perception.