Two significant catalysts for declining inflation are simultaneously materializing, providing ample justification for Federal Reserve Chair Waller to adopt a more dovish stance at this week's Federal Open Market Committee (FOMC) meeting.
According to a research report from Citigroup dated June 15th, the anticipated reopening of the Strait of Hormuz is expected to drive oil prices lower, removing the upside inflation risk from energy prices. Concurrently, last week's core CPI data came in notably soft, with a month-over-month increase of just 0.21%.
The combination of these developments further undermines the rationale for the Fed to maintain a hawkish posture, bringing potential interest rate cuts back into the discussion.
For markets, this assessment carries direct pricing implications. The yield on the 2-year U.S. Treasury note has fallen by approximately 13 basis points from a week ago, yet remains more than 60 basis points above its February level. This indicates room for the market to further price out rate hikes and potentially price in more rate cuts.
Energy Price Pressures Ebb, Inflation Upside Risks Fade
The expectation of the Strait of Hormuz reopening is a central driver of the current dovish narrative. Should the strait reopen, increased crude oil supply would push down oil and other energy prices.
Gasoline prices have already declined for a month, with the national average falling from about $4.50 to $4.00 per gallon. Citi anticipates further declines in line with other energy commodities. This trend is projected to produce several months of negative headline inflation readings in the coming months, likely leading Fed officials to reclassify energy prices from an "inflation risk" to a "neutral or even deflationary factor."
Core CPI Cools, Divergence Among Inflation Gauges Widens
On the core inflation front, while May's core PCE is still expected to remain robust, core CPI has shown clear signs of cooling, posting a mere 0.21% monthly increase.
Core PCE is increasingly becoming an outlier among inflation measures. Both the trimmed-mean PCE and core CPI are closer to target and exhibit clearer downward trends. This divergence is being increasingly recognized by both markets and Fed officials, providing data support for a dovish shift.
FOMC Hawkish Adjustments Already Priced In, Dovish Signals Offer Upside Potential
The report expects this week's FOMC statement to remove "easing bias" language, and the median dot in the interest rate projections to indicate no rate cuts this year. However, these hawkish adjustments are already fully anticipated by the market and do not constitute new information.
The true variable lies in Chair Waller's rhetorical tone. Given the latest developments regarding the Strait of Hormuz and the cooling trend in core inflation, the risk that Waller delivers a more dovish signal at this meeting is tilted to the upside. If his language is more accommodative than expected, the market's repricing of the rate cut path could accelerate.
U.S. Treasury Yields Have Further Room to Fall, Market Pricing Can Adjust
From a market pricing perspective, the report suggests that interest rate futures still imply an overly high probability of further rate hikes. Although the 2-year Treasury yield has fallen about 13 basis points from last week, it remains over 60 basis points above its February level, indicating the market has not fully digested the easing of inflation risks.
As the inflation upside risks that previously supported hawkish expectations gradually dissipate, the market is poised to further price out hikes while simultaneously pricing in more cuts, suggesting U.S. Treasury yields still have room to decline.
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