Markets Have Priced Out Rate Cuts. What Changed?

In January, markets were still convinced the Fed would cut rates. At the time, interest-rate futures, as shown by CME FedWatch, assigned only an 8% probability to no cuts at all during the year. Fed Chair Jerome Powell also said that rate increases were not the baseline scenario.

The Reversal: Rate Cuts Now Look Almost Impossible

As of September 8, CME FedWatch showed that the probability of a September cut had fallen to zero, while the probability of a 25-basis-point increase had risen to 60.4%. In just nine months, markets had moved from treating cuts as almost certain to treating them as almost impossible. This is not a mathematical statement that the probability is exactly zero; it is how the possibility is being priced.

What Overturned Expectations for Cuts?

It was not a single event, but three forces acting together.

First, inflation. July CPI inflation was 3.4% year on year, and core PCE was still at 3.3%. The narrative that inflation would fall had lasted from spring through autumn without being realized. Without lower inflation, the case for cuts could not hold.

Second, a change in Fed leadership. Powell left the chair in May, and the hawkish Warsh took over. At the late-August Jackson Hole meeting, he said he was not confident inflation was returning to 2% and that there was more work to do. The policy framework shifted from protecting employment towards restraining inflation, removing the premise for rate cuts.

Third, the apparent stumble in employment was disproved. On August 7, July payrolls were reported to have fallen by 23,000, briefly lowering the probability of a September hike from about two-thirds to around 40%. Markets nearly concluded that a cut might be coming. But on September 4, August payrolls rose by 162,000, and July's figure was revised up to a gain of 21,000. The feared employment collapse had been a false alarm.

Cuts Are Priced Out, but a Hike Is Not Settled

Current pricing assigns a zero probability to a September cut, a 60.4% probability to a hike and a 39.6% probability to unchanged rates. Markets have not fully converged on a hike because the Fed has retained flexibility.

On September 3, Waller said the Fed could hold steady if inflation continued to decline. The latest payroll report showed August hourly earnings rising by 3.1% year on year, the slowest pace since the pandemic. Wage pressure did not appear to be out of control.

The current macroeconomic picture is one of relatively strong employment and sticky inflation, but the conditions required to trigger a hike are not yet fully in place.

How Should We Read the September 11 CPI Release?

U.S. August CPI will be released at 20:30 Beijing time on September 11. The key figure is the month-on-month change in core CPI:

- At or below 0.2%: inflation continues to cool, expectations for a hike recede, and markets begin discussing the possibility of cuts again.

- At or above 0.3%: inflation picks up again, expectations for a hike strengthen, and cuts move completely out of the picture.

Oil remains a variable, however. Driven by the U.S.–Iran conflict, Brent crude rose 7.6% in the week ending September 5, creating upward pressure on CPI through its energy component. This CPI report may determine whether markets face a third major turn in expectations.