Citi noted that two catalysts—declining oil prices and a cooldown in core CPI—are unfolding simultaneously: expectations of the Strait of Hormuz reopening have pushed down energy prices, while core CPI rose just 0.21% month-over-month in May, accelerating the erosion of the Fed's hawkish rationale. The probability of Kevin Warsh delivering a dovish signal at this week’s FOMC meeting has tilted upward, leaving significant room for further declines in the two-year U.S. Treasury yield, with repricing toward rate cuts potentially imminent.
Two key catalysts driving inflation lower are simultaneously gaining momentum, providing ample justification for Fed Chair Waller to adopt a dovish stance at this week’sFederal Open Market CommitteeFOMC meeting.
According to Chasing the Wind trading desk, a Citi Research report released on June 15 noted that the anticipated reopening of the Strait of Hormuz would push oil prices lower, thereby eliminating the upward risk to inflation from energy prices. Meanwhile, last week’s core CPI data came in notably soft, rising just 0.21% month-over-month.
The confluence of these two developments further weakens the rationale for the Fed to maintain a hawkish stance, bringing the path toward eventual rate cuts back onto the table.
For markets, this assessment carries direct pricing implications. The yield on two-year U.S. Treasuries has declined by approximately 13 basis points since a week ago, yet remains more than 60 basis points above February levels. Market pricing still has room to compress further regarding rate hikes and additional scope to price in rate cuts.
Energy price pressures ease, muting upside inflation risks
Expectations of the Strait of Hormuz reopening are among the central drivers of the current dovish narrative. Once navigation through the strait resumes, increased crude supply will drive down oil and other energy prices.
Gasoline prices have declined for a consecutive month, falling nationally from around $4.50 per gallon to $4.00 per gallon. Citi expects them to continue declining in line with other energy commodities. This trend is likely to generate several months of negative headline inflation readings and prompt Fed officials to reclassify energy prices from an “inflation risk” to a “neutral or even disinflationary factor.”
Core CPI cools further, widening divergence among inflation indicators
On core inflation, while May’s core PCE is still expected to remain robust, core CPI has shown clear signs of cooling, rising only 0.21% month-over-month.
Core PCE is increasingly becoming an outlier among various inflation metrics—the trimmed-mean PCE and core CPI are both closer to target and exhibit clearer downward trends. This divergence is being increasingly recognized by both markets and Fed officials, providing further data support for a dovish stance.
The hawkish shift by the FOMC has already been fully priced in, leaving room for upside from any dovish commentary.
The report expects the FOMC statement this week to remove the phrase 'accommodative bias,' and the median projection in the dot plot will indicate no rate changes for the remainder of the year. However, this hawkish adjustment is already fully anticipated by markets and does not represent new information.
The key variable lies in Waller’s tone. Against the backdrop of the latest developments regarding the reopening of the Strait of Hormuz and the cooling trend in core inflation, the risk of Waller delivering a dovish signal at this meeting is tilted to the upside. Should his remarks prove more dovish than expected, market repricing of the rate-cut path could accelerate.
U.S. Treasury yields still have room to decline, and market pricing remains subject to adjustment.
From a market-pricing perspective, the report notes that current interest rate futures still imply an elevated probability of a rate hike. Although the 2-year U.S. Treasury yield has declined by approximately 13 basis points from a week ago, it remains over 60 basis points higher than February levels, indicating that markets have not yet fully absorbed the implications of easing inflation risks.
As the previously supportive upside inflation risks underpinning hawkish expectations gradually dissipate, markets are likely to further compress pricing for rate hikes and simultaneously increase pricing for rate cuts, leaving room for U.S. Treasury yields to move lower.
Editor/Lambor