The Fed's case for rate cuts is closing

April CPI figures confirm the energy shock is bleeding into underlying prices; markets are now pricing a 34% chance of a rate hike by year end.

Summary

• Inflation Continues to Surge: Headline CPI-based inflation surged to a 3.8% twelve-month pace in April on a 17.5% y/y jump in energy prices due to the Iran war. More concerningly, core inflation accelerated to a 2.7% twelve-month pace and a 4.6% annualized one-month pace. Core inflation is trending higher before the full effects of elevated headline inflation have passed through.
• Considering Policy Hikes: A Fed cutting cycle this year is pretty much off the table amid clearly rising inflation expectations, which climbed to a three-year high in April. While market consensus is for no change in the policy rate this year, serious consideration should be given to the possibility that a rate hike might be taken if the Strait of Hormuz remains closed. CME futures are pricing a 34% probability of at least one hike by year-end, up materially from prior weeks, though the no-cut outcome remains consensus at 63%.
• Rising Bond Yields: The 2y yield has traded back near 4% - a level that already prices some tightening. We see further upside in the 10y, likely toward 4.5% as inflation expectations and deficit concerns build. We are bullish USD, with DXY looking too weak given restricted energy supplies and a step back in expectations for Fed easing. USD should see particular strength against energy import dependent economies.

Market Analysis

Even ahead of the Iran war, the outlook for US inflation was elevated. Fiscal stimulus, aggressive AI-related capital expenditures, and the potential for some limited monetary easing all lifted the outlook for growth, and inflation. Ahead of the Iran war, we had forecasted a 3.1% rate of headline inflation, and a 3% rate of core inflation, both of which were already far above the Fed’s 2% target. Today’s CPI report, which includes consumer price information for April, clearly points to a US inflation environment that is likely to finish well above our previous forecast.

One- and Twelve-Month Pace of CPI-Based Headline Inflation (%)

Source: BLS; data is seasonally adjusted

Headline CPI-based inflation (seasonally adjusted), which includes volatile food and energy, understandably surged in April, finishing at a twelve-month pace of 3.8%, lifted by a one-month pace of inflation that surged to 10.9% annualized in March, and 8% annualized in April. Energy prices are the main culprit with the twelve-month pace of inflation across the category at 17.5% in April, up from just 0.4% in February, ahead of the Iran war.

The question is the extent to which headline inflation feeds through to core inflation, which excludes volatile food and energy. Core inflation is often what the Fed will utilize when considering monetary policy. It is hard to ascertain the extent of pass through for now, but core inflation clearly accelerated in April, with both the twelve-month (2.7%, +14bp against March) and the one-month (4.6% annualized, +223bp against March) rate of inflation rising against the March report. This is a bad sign. A situation where core inflation is already trending higher before the effects of elevated headline inflation pass through is highly problematic.

One- and Twelve-Month Pace of CPI-Based Core Inflation (%)

Source: BLS; data is seasonally adjusted

Our view for over a month is that hopes of a Fed cutting cycle this year are misplaced. While supply-side shocks are hard to control through monetary policy, cutting rates in such an environment risks de-anchoring consumer inflation expectations, which were already too high ahead of the Iran war. In April, the Fed’s measurement of year-ahead inflation expectations rose to 3.3%, the highest level in over three years, and well above the Fed’s 2% target. We expect expectations to remain elevated.

At this point, one must seriously consider the potential for rate hikes. The bar is high, particularly as a new Trump-leaning Fed chairman enters the role, but one should not discount the possibility the FOMC goes for a hike. In mid-April, we argued that rate hikes were a distinct possibility if the Strait of Hormuz remained closed into May. CME rate futures have begun to price in the possibility of monetary tightening. As of May 12, the probability of at least a single rate hike by the end of 2026 had risen to 34%. The no cut outcome remains the consensus at 63%.

Fed Funds End 2026 Probabilities (%)

Source: CME

The bond market seems to be settling on a slightly tighter monetary policy posture. The 2y, often a reflection of the outlook for the Fed, has nearly traded back towards 4%, a level we feel makes sense right now. A 4% level on the 2y effectively prices some limited degree of monetary tightening. Where there is likely to be more movement is further out the curve. The 10y has rallied back towards the post-Iran war high around 4.45%, but we feel there is further upside, likely towards 4.5% as higher inflation expectations, and concerns about deficit spending play a bigger role. A re-widening of the 2s – 10s curve back towards 0.5% seems possible in the next few weeks.

We are also bullish USD. Rising US inflation limits the outlook for Fed easing. In addition, the US enjoys the position of being a major energy exporter at the moment of a real energy supply crisis. The US growth environment also continues to hold up for now. DXY, which represents a weighted basket of currencies against USD, looks too weak with the index trading at the low end of the post-Iran range. Intervention in USD/JPY, in particular, has kept DXY from appreciating too much. Nonetheless, if the conflict with Iran persists, and oil prices climb higher, long-USD is a good bet, particularly against economies that are highly import dependent.

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