Markets are notorious for exaggerated expectations. They sense a tiger when all they see is a cat. Expectations on rate cuts have been no different. Despite the Fed’s speak on measured changes to policy rates, markets got ahead of themselves since late last year. Markets are now starting to align their expectations with reality.
US economic data from January stands in stark contrast to December readings. Nonfarm payrolls and CPI are higher than expectations. A resilient economy and rebound in inflation have pushed expectations of rate cuts to much later this year.
According to the CME Group FedWatch tool, the probability of a rate cut at the March FOMC policy meeting dropped from 73% on 29 Dec 2023 to merely 8.5% as of 19 Feb 2024. First rate cut is now expected at the 12 June policy meeting this year. Markets are now pricing four rate cuts instead of six cuts as previously anticipated.
Shift in rate cut expectations has led to a rebound in US treasury bond yields. This paper delves into the factors behind the shift in rate expectations. The paper also analyses a hypothetical trade setup using CME Group Yield futures that investors can deploy to harness gains from revised policy path ahead.
RATE CUT EXPECTATIONS IS BECOMING MORE ROOTED IN REALITY NOW
A stream of recent economic data from the US has pointed to a stronger economy and a rebound in inflation, causing rate cut expectations to shift.
January nonfarm payrolls report showed 353k jobs added, exceeding expectations of 333k and the largest build since January 2023. January CPI report showed annual CPI growth slow from its pace of 3.4% in December 2023 to 3.1% in Jan 2024 but still hotter than analyst expectations of 2.9%.
Core CPI was another concern as it stood unchanged at 3.9%. On a monthly basis, CPI jumped 0.3% MoM. 0.6% MoM increase in rent prices and 0.4% increase in food prices were behind the monthly increase.
On the positive front, PPI fell 0.1% MoM in January, with goods prices 0.4% lower. PPI is just 1% higher YoY against an estimate of +1.3% estimate.
January Retail Sales fell sharply by 0.8% MoM in January. December growth was revised lower from +0.6% to +0.4%. This is expected to lead to a lower GDP growth in Q1. GDPNow model from the Atlanta Fed predicts 2.9% growth in Q1, compared to 3.4% before the release.
As a result of the broadly stronger data and higher inflation, expectations of rate cuts at the 20/March FOMC meeting have fallen from their peak of 74% on 29 December 2023 to 8.5% as of 19 February 2024. Expectations for a rate cut by May have also been scaled back. As of 14 Feb 2024, there is just 35% probability of a rate cut at the 01 May FOMC meeting as well.
FedWatch indicates 50% probability of a rate cut for the meeting on 12 June 2024, which is up from 40% a week ago.
The increase reflects the recent retail sales and jobless claims data that was stronger than expected. Both have led to a pullback in bond yields from their 2024 highs.
The CME Group FedWatch tool indicates expectations of four rate cuts in 2024 as of 18/Feb down from six cuts at the start of the year.
The expectations around rate cuts have also shifted in Fed’s messaging. Atlanta Fed President Raphael Bostic stated that the Federal reserve does not face any urgency in cutting rates due to the current strength in the US economy. Dallas Fed President, Lorie Logan, shares similar sentiments.
Fed Chair Powell echoed the same message. Powell stated the Fed won’t cut rates until it has greater confidence that inflation is moving sustainably to its target. Specifically, he mentioned that a rate cut was unlikely by March. In an interview with “60 Minutes”, Powell suggested that Fed’s base case scenario of 75 basis points of rate cuts in 2024 was unchanged.
As a result of delayed rate cuts expectations, US treasury yields have rebounded.
FOMC MINUTES TO REITERATE HAWKISH POSTURE
Strong economic data and inflation numbers coming in hotter than expected will keep the Fed hawkish in the near term. How long will be anybody's guess?
On 21/Feb (Wed), minutes of the FOMC January meeting will be published. Expectations are for Fed to reiterate its hawkish posture. In anticipation, the 2-year yield futures are up forty-nine basis points (bps) to close at 4.601% as of 16/Feb (compared to 4.112% close of markets on 1/Feb).
Meanwhile, during the same period, the 10-year yield futures jumped forty-five bps to close at 4.295% as of close of markets on 16/Feb.
Taking directional views on the 2-year or the 10-year yields can be difficult when rate expectations are already baked into the yields. Directional views expose the trade to large downside risks vastly reducing reward-to-risk ratio.
In sharp contrast, spread trades enables trades to lock in gains while minimizing downside risks. This paper illustrates a hypothetical treasury spread trade below.
HYPOTHETICAL 10Y-2Y TREASURY SPREAD TRADE
Portfolio managers can better harvest gains from rate moves by trading the closely monitored US Treasury yield spread measuring the gap between yields on 2-year & 10-year Treasury notes. FOMC minutes reiterating a hawkish posture will invert the yield curve even more.
To help traders monitor this spread, the CME Group publishes a Micro Treasury CurveWatch tool which shows daily, weekly, and monthly changes in yields and major yield spreads.
Portfolio managers can express this view by taking a short position in the CME Group 10-Year Yield Futures (10YG4) and a long position in the CME Group 2-Year Yield Futures (2YYG4).
● Entry: -0.2790 (27.9 bps; enter the spread trade when 10YG4 minus 2YYG4 is -0.2790 bps)
● Target Exit: -0.3690 (36.9 bps)
● Stop Loss: -0.2250 (22.5 bps)
● Profit at Target: USD 90 (9 bps x USD 10)
● Loss at Stop: USD 54 (5.4 bps x USD 10)
● Reward to Risk: 1.66x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
US economic data from January stands in stark contrast to December readings. Nonfarm payrolls and CPI are higher than expectations. A resilient economy and rebound in inflation have pushed expectations of rate cuts to much later this year.
According to the CME Group FedWatch tool, the probability of a rate cut at the March FOMC policy meeting dropped from 73% on 29 Dec 2023 to merely 8.5% as of 19 Feb 2024. First rate cut is now expected at the 12 June policy meeting this year. Markets are now pricing four rate cuts instead of six cuts as previously anticipated.
Shift in rate cut expectations has led to a rebound in US treasury bond yields. This paper delves into the factors behind the shift in rate expectations. The paper also analyses a hypothetical trade setup using CME Group Yield futures that investors can deploy to harness gains from revised policy path ahead.
RATE CUT EXPECTATIONS IS BECOMING MORE ROOTED IN REALITY NOW
A stream of recent economic data from the US has pointed to a stronger economy and a rebound in inflation, causing rate cut expectations to shift.
January nonfarm payrolls report showed 353k jobs added, exceeding expectations of 333k and the largest build since January 2023. January CPI report showed annual CPI growth slow from its pace of 3.4% in December 2023 to 3.1% in Jan 2024 but still hotter than analyst expectations of 2.9%.
Core CPI was another concern as it stood unchanged at 3.9%. On a monthly basis, CPI jumped 0.3% MoM. 0.6% MoM increase in rent prices and 0.4% increase in food prices were behind the monthly increase.
On the positive front, PPI fell 0.1% MoM in January, with goods prices 0.4% lower. PPI is just 1% higher YoY against an estimate of +1.3% estimate.
January Retail Sales fell sharply by 0.8% MoM in January. December growth was revised lower from +0.6% to +0.4%. This is expected to lead to a lower GDP growth in Q1. GDPNow model from the Atlanta Fed predicts 2.9% growth in Q1, compared to 3.4% before the release.
As a result of the broadly stronger data and higher inflation, expectations of rate cuts at the 20/March FOMC meeting have fallen from their peak of 74% on 29 December 2023 to 8.5% as of 19 February 2024. Expectations for a rate cut by May have also been scaled back. As of 14 Feb 2024, there is just 35% probability of a rate cut at the 01 May FOMC meeting as well.
Source: CME Group FedWatch
FedWatch indicates 50% probability of a rate cut for the meeting on 12 June 2024, which is up from 40% a week ago.
Source: CME Group FedWatch
The increase reflects the recent retail sales and jobless claims data that was stronger than expected. Both have led to a pullback in bond yields from their 2024 highs.
Source: CME Group FedWatch
The CME Group FedWatch tool indicates expectations of four rate cuts in 2024 as of 18/Feb down from six cuts at the start of the year.
The expectations around rate cuts have also shifted in Fed’s messaging. Atlanta Fed President Raphael Bostic stated that the Federal reserve does not face any urgency in cutting rates due to the current strength in the US economy. Dallas Fed President, Lorie Logan, shares similar sentiments.
Fed Chair Powell echoed the same message. Powell stated the Fed won’t cut rates until it has greater confidence that inflation is moving sustainably to its target. Specifically, he mentioned that a rate cut was unlikely by March. In an interview with “60 Minutes”, Powell suggested that Fed’s base case scenario of 75 basis points of rate cuts in 2024 was unchanged.
As a result of delayed rate cuts expectations, US treasury yields have rebounded.
FOMC MINUTES TO REITERATE HAWKISH POSTURE
Strong economic data and inflation numbers coming in hotter than expected will keep the Fed hawkish in the near term. How long will be anybody's guess?
On 21/Feb (Wed), minutes of the FOMC January meeting will be published. Expectations are for Fed to reiterate its hawkish posture. In anticipation, the 2-year yield futures are up forty-nine basis points (bps) to close at 4.601% as of 16/Feb (compared to 4.112% close of markets on 1/Feb).
Meanwhile, during the same period, the 10-year yield futures jumped forty-five bps to close at 4.295% as of close of markets on 16/Feb.
Taking directional views on the 2-year or the 10-year yields can be difficult when rate expectations are already baked into the yields. Directional views expose the trade to large downside risks vastly reducing reward-to-risk ratio.
In sharp contrast, spread trades enables trades to lock in gains while minimizing downside risks. This paper illustrates a hypothetical treasury spread trade below.
HYPOTHETICAL 10Y-2Y TREASURY SPREAD TRADE
Portfolio managers can better harvest gains from rate moves by trading the closely monitored US Treasury yield spread measuring the gap between yields on 2-year & 10-year Treasury notes. FOMC minutes reiterating a hawkish posture will invert the yield curve even more.
To help traders monitor this spread, the CME Group publishes a Micro Treasury CurveWatch tool which shows daily, weekly, and monthly changes in yields and major yield spreads.
Source: Micro Treasury CurveWatch tool
Portfolio managers can express this view by taking a short position in the CME Group 10-Year Yield Futures (10YG4) and a long position in the CME Group 2-Year Yield Futures (2YYG4).
● Entry: -0.2790 (27.9 bps; enter the spread trade when 10YG4 minus 2YYG4 is -0.2790 bps)
● Target Exit: -0.3690 (36.9 bps)
● Stop Loss: -0.2250 (22.5 bps)
● Profit at Target: USD 90 (9 bps x USD 10)
● Loss at Stop: USD 54 (5.4 bps x USD 10)
● Reward to Risk: 1.66x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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