INTERNAL NOTE — MACRO DESK

Re: The Energy Trade Has Turned. Update Your Models.

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Brent closed at $73.74 on Wednesday. WTI at $70.34. Both at their lowest level since before the US and Israel launched strikes on Iran in late February. From the wartime peak — Brent was above $120 at the height of the panic — that's a collapse of roughly 40%. Four months. Forty percent.

The consensus narrative in rates markets right now is that the Fed is going to hike three times before December. BofA flipped from zero hikes to 75 basis points of tightening in the span of one FOMC meeting. Deutsche Bank penciled in two. The June dot plot showed nine of eighteen FOMC members expecting at least one increase. CME FedWatch has December hike probability at 87.9%. The market is nearly fully priced for a new tightening cycle.

Every piece of that view was anchored to the May CPI print: 4.2% year-over-year, the highest since April 2023. The headline number looked genuinely alarming. It was. Energy costs were up 23.5% annually. Gasoline was up 40.5%. Fuel oil up 58.9%. Energy accounted for over sixty percent of the monthly all-items increase. The core, stripped of food and energy, came in at 2.9% — uncomfortably above target, but not on fire. The headline number made the news. The headline number is what Kevin Warsh talked about when he said the Fed's inflation problem had gotten "unambiguously worse." It's what prompted BofA economist Aditya Bhave to reverse an entire year's worth of forecasting in a week.

Here is the problem. That data described May. Oil in May was still substantially elevated by the war premium. The price of WTI averaged above $90 in March. It was in the mid-80s in April. The May read on energy was surveying a world that no longer exists.

The Hormuz deal is working. Tanker traffic through the strait is recovering. Shipowners are transiting with active satellite signals following safety guarantees from the IMO. The International Energy Agency estimates the UAE is now exporting at nearly 85% of pre-war levels. Approximately sixty million barrels have moved from the Persian Gulf recently. The infrastructure is damaged, the pipeline to full normalization is months long, and the geopolitical situation remains volatile — Iran shut the strait again briefly last week, then reopened it — but the direction of travel on oil prices is unambiguous. Down.

This matters for the inflation math in ways that won't show up in the data until it's too late for the Fed to act on them in September.

The June CPI report publishes July 14th. May PCE dropped this morning. The CPI number that will actually be available when the FOMC meets in late July will be for June — priced off an oil market that's spent most of this month between $70 and $80. By September, when BofA thinks the first hike will land, the July and August energy data will both be deflationary relative to the year-ago comparisons from when the war premium was fully loaded. Mechanically, the headline CPI trajectory rolls over. Sharply. The annual comps get genuinely easy.

Warsh knows this, which is why he keeps saying he doesn't want to react to supply-shock inflation. The problem is the Fed already has reacted — not by hiking, but by revising its PCE forecast to 3.6%, stripping out the dovish guidance, and giving BofA and Deutsche Bank exactly enough signal to write hawkish notes that the entire rates market then repriced around.

So we're now in a situation where: the headline inflation reading that spooked everyone was 60% driven by an energy component that has since reversed; the oil price that will feed into the next three months of CPI is running 15-20% below the levels that generated the May shock; housing disinflation hasn't fully returned but shelter is decelerating; and core CPI was 2.9%, which is above target but not the kind of number you build a three-hike cycle on.

The market has priced in a hawkish Fed based on a data set that is already partially obsolete.

What it has not priced is the scenario where June PCE comes in soft, July CPI prints below 3.5% on easy energy comps, and Warsh walks into the July meeting with no case to hike. He doesn't have to do anything dramatic. He just has to do nothing — which is what the Fed did three meetings in a row before this one. If the data defends a hold in July, and the September number also comes in soft, BofA's three-hike call starts to look like the kind of forecast that gets quietly revised away in a subsequent note.

There's a caveat worth taking seriously. US crude inventories just plunged to their lowest level since 1984. Cushing stockpiles have dipped below operational minimums. The inventory depletion is structural — not seasonal noise — and it reflects months of disrupted supply flowing through a system that couldn't absorb the shock cleanly. Once the current glut of vessels queued outside the Strait clears, and the restored supply hits a depleted inventory base, the price dynamics could reverse faster than the market expects. OPEC has already rejected IEA forecasts of a looming supply glut. They're not wrong to be skeptical.

The oil collapse is real but may be shorter-lived than it currently appears. The inflation relief it provides in June and July CPI may be a window, not a trend. The question for the Warsh Fed is whether it mistakes a transitory reprieve for a durable return to target — the same mistake Powell made in reverse during the 2021-22 inflation surge.

The irony of the current situation is that the Fed's inflation credibility problem might ultimately be solved not by anything it does, but by the reopening of a shipping lane in the Persian Gulf. That's not a framework. That's luck.

Update your models. The data is changing faster than the consensus.