Core PCE: Is the Fed Credibility Trade About to be Tested?

Earlier this week I published a research note examining a simple question:

When markets price a more restrictive Federal Reserve, what has historically been the best trade?

Using daily data across rates, FX, commodities and equities since 2019, I found that the strongest historical expression was not precious metals, but the US dollar.

With today’s Core PCE release approaching, I wanted to take that framework one step further. Rather than forecasting the inflation number itself, this note asks a different question:

What is the market already pricing—and what would actually change the current Fed credibility narrative?

As always, comments and alternative views are very welcome.

Markets enter today’s Core PCE release in a very different position from just a few days ago.

• US 2-year Treasury yields have retraced to around 4.14%.

• Brent crude has fallen sharply to around $72.6/bbl.

• Gold has fallen below $4,000/oz.

• Silver has declined towards $57.5/oz.

• Speculative USD positioning has become increasingly extended.

At first glance these moves appear contradictory. Lower Treasury yields would normally be expected to weaken the dollar and support precious metals.

Instead, the opposite has occurred.

Perhaps the most interesting observation is that the M7-M8 SOFR futures spread remains close to -25bp despite the decline in Treasury yields and the sharp fall in oil prices.

In other words, markets have eased some of the near-term hawkish pricing without materially changing their view that policy rates are likely to remain elevated further out the curve.

It suggests investors are adjusting the timing of policy rather than abandoning the higher-for-longer narrative altogether.

The Market Is Trading More Than Rates

One conclusion from the historical study was that the US dollar is the first-order expression of hawkish repricing, while precious metals often respond only when real yields confirm the move.

Recent price action suggests the market may now be trading something broader.

Rather than focusing solely on front-end interest rates, investors appear increasingly focused on:

• confidence in the Federal Reserve’s willingness to maintain restrictive policy;

• relative US economic resilience;

• continued global demand for US dollar liquidity;

• widening policy divergence, particularly versus China.

The continued depreciation of the renminbi is interesting. Despite lower Treasury yields, Chinese authorities have continued to allow USD/CNH to appreciate, reinforcing broader USD strength rather than offsetting it. (Higher CNY fixing today but USDCNH stabilised with Corporate selling and Equity inflows)

Today’s Core PCE Release

Today’s inflation data should therefore be viewed less as a question of whether Core PCE is one tenth above or below expectations, and more as a test of whether investors continue to believe in a structurally more restrictive Federal Reserve.

Scenario 1 – Softer Core PCE

A softer-than-expected print would probably trigger:

• lower US 2-year yields;

• a less negative M7-M8 SOFR spread;

• some USD profit-taking;

• support for gold and higher-beta currencies such as AUD and NZD.

However, I suspect the downside in the dollar may prove more limited than many expect.

The more important question is not whether front-end yields fall, but whether investors materially reduce their estimate of the long-run policy rate. If longer-dated forwards remain relatively resilient, any USD weakness is likely to prove corrective rather than structural.

Scenario 2 – In-Line Core PCE

This may be the most underappreciated outcome. Markets have already retraced part of last week’s hawkish move. An in-line print may simply reinforce the current regime.

Historically that has favoured:

• Long USDCHF;

• Long DXY;

• Short NZDUSD;

• Short AUDUSD.

while leaving precious metals primarily dependent on the direction of real yields.

Scenario 3 – Firmer Core PCE

A stronger inflation print would reopen the higher-for-longer narrative. , If accompanied by stable long-term inflation expectations, markets may increasingly interpret the move as evidence of renewed Fed credibility rather than an inflation scare.

Historically, that environment has favoured:

• broad USD strength;

• renewed pressure on AUD and NZD;

• higher real yields;

• continued weakness in precious metals.

Positioning: Crowded, But Not Trapped

One of the strongest arguments against the bullish USD view is positioning. Speculative positioning in DXY is now close to its highest levels since January. Ordinarily that would argue for caution.

However, there is an important distinction between crowded positioning and trapped positioning. Long USD positions have been consistently rewarded rather than trapped. That makes current positioning look more like conviction than exhaustion. Positioning can certainly amplify volatility around today’s data release. But unless the underlying macro narrative changes, it is rarely sufficient on its own to end a trend.

Looking Beyond Today

The next stage of this research will examine whether markets respond differently when hawkish repricing is driven by:

• higher outright forward rates;

• rising real yields; or

• falling long-term inflation expectations.

That distinction may ultimately prove more important than today’s inflation number.

The key question is no longer simply whether the Federal Reserve remains restrictive. It is whether markets continue to believe the Federal Reserve will ultimately succeed in returning inflation to target. (and Oil/ Gasoline prices may certainly help - have a listen to the podcast from David Kelly, which I summarised on an earlier post)

Today’s Core PCE release should provide the first real test of that framework.

Next in the series: Fed Credibility or Inflation Scare? A cross-asset study of how policy expectations, real yields and long-term inflation expectations interact to drive FX, commodities and risk assets.