Annotating a rate cut in September! The market still goes against the Federal Reserve

The market is doubling down on betting on rate cuts, even as the tough stance of the Federal Reserve fails to shake their confidence.

Overnight, the Federal Reserve kept rates unchanged at a high level for over two decades and lowered its rate cut expectations for this year. Nearly half of the FOMC officials expect only one 25 basis point rate cut. Powell reiterated in a subsequent press conference that the Fed has no plans for rate cuts at the moment and will continue to observe more evidence to ensure that inflation is moving in the expected direction.

However, the market did not pay attention to this hawkish stance. The CPI released earlier in the night showed a cooling inflation, with May's core CPI falling to a three-year low. This prompted the market to increase bets on two rate cuts this year, with the first rate cut potentially happening as soon as September.

The market celebrated, with U.S. stocks and bonds rising together. The two-year U.S. Treasury yield fell by as much as 17 basis points to a low of 4.67%, and the S&P 500 index rose by as much as 1.3%. After the end of the Fed meeting, the market largely maintained its upward trend, showing a muted response to Powell's hawkish comments.

In recent years, the market has often over-speculated that the Fed is about to change course, only to suffer heavy losses when the Fed "sticks to the plan."

However, this time the Fed has clearly stated that once they are confident that inflation will fall back to the 2% target, they will begin cutting rates.

Bloomberg strategist Cameron Crise said:

A CPI data significantly lower than expected has traders ecstatically buying assets, which is understandable as the key indicator core CPI has undergone a sudden shift.

However, on the surface, the Fed's dot plot and economic forecasts are quite hawkish, with inflation expectations raised and the median federal funds rate for 2024 standing firm at 5.125%.

Even so, the hawkishness of the dot plot (in terms of reaction function) is not as strong as in previous times, and if the inflation trajectory continues to decline, the Fed may further shift towards a more dovish stance, which seems to explain the market's appropriate response to the CPI data.

Powell also seems to agree with the market's rate forecasts, downplaying the importance of the dot plot and stating that the actual path will depend on future economic data. He mentioned that the May inflation data is "welcome," and officials hope to see more data like that. George Goncalves, head of U.S. macro strategy at MUFG, commented:

Powell is appearing more hawkish, just trying to shift the focus away from the timing of the first rate cut