While bond traders and much of Wall Street are positioned for potential rate hikes, Andrew Hollenhorst, Citi's Chief US Economist, asserts that the Federal Reserve will cut interest rates this year, driven by a softening labor market and declining oil prices.

Hollenhorst points out that this week's drop in energy prices, following a US-Iran agreement to reopen the Strait of Hormuz and extend a ceasefire, provides space for Fed Chair Kevin Wash to adopt a dovish stance at this week's policy meeting.

"This gives him greater flexibility," Hollenhorst stated. "That inflationary pressure has now reversed and turned into disinflationary pressure."

Brent crude fell below $80 a barrel on Tuesday for the first time in three months, influenced by the news. The drop in oil prices has cooled inflation expectations, subsequently loosening market expectations for Fed rate hikes.

Last week, traders had fully priced in a 25-basis-point rate hike by the FOMC in December, but that probability has since declined.

Following the outbreak of conflict in the Middle East, predictions for Fed rate cuts this year became increasingly rare due to rising oil prices and strong job growth, with traders who had previously bet on multiple cuts abandoning those positions.

Earlier this month, despite a robust US May jobs report that reinforced market expectations for the Fed to maintain high rates or even restart hikes, Citi maintained its view that the Fed will implement three rate cuts this year.

At the time, Hollenhorst noted that the strong jobs report would undoubtedly lead Fed officials to focus more on inflation upside risks rather than labor market weakness at the June meeting. However, he expects the US labor market to cool gradually over the next three months, prompting markets to reprice rate cut expectations.

"Signs of labor market weakness will become more apparent in the coming months, and the market's focus will eventually shift back from hike risks to cut possibilities," Hollenhorst said.

Currently, Hollenhorst anticipates that central bank officials will remove language suggesting a dovish bias from their policy statement and issue forecasts showing no rate cuts this year. Nonetheless, Citi's base case remains three Fed rate cuts starting in September, contingent on continued labor market weakening in the coming months.

Hollenhorst added that if this scenario does not materialize, the timing of cuts could be pushed back to 2027.

The recent market environment has shifted notably. The retreat in energy prices has alleviated concerns about persistent inflation and led some investors to revisit the possibility of future rate cuts, though a consensus has not formed.

Many investors believe that even with lower oil prices, the robust US economy and job market could still lead the Fed to tighten policy further.

Over the past week, options trading linked to Fed rate expectations surged, at times 50% above normal levels. Notably, the new trades were not concentrated in one direction. Some investors are betting on a Fed rate hike as soon as late this year or early next.

Concurrently, other investors still believe in future rate cuts, though they have pushed the expected timing to the first half of next year.

Jeff Schuh, Head of Rates Trading at Constitution Capital, remarked, "The market hasn't given up on rate cut expectations; it just thinks they may take longer to materialize." In other words, investors are increasingly leaning toward the Fed holding rates at current levels for an extended period.

Compared to Citi, some institutions hold more hawkish forecasts for the Fed's rate outlook. PGIM projected this week that the Fed could implement three consecutive rate hikes this year. BNP Paribas believes the Fed will start hiking in December, with a cumulative total of three increases.

The Federal Reserve will announce its interest rate decision and Summary of Economic Projections at 2:00 AM Beijing Time on June 18. New Fed Chair Kevin Wash will hold his first monetary policy press conference. Markets currently expect the Fed to hold rates steady this week.

Analysis suggests that despite data last week showing US inflation accelerating due to surging energy costs, the probability of a near-term Fed hike remains low. The market is now eager to ascertain Wash's policy stance—if he demonstrates a strong, hawkish anti-inflation resolve in the face of overheated data, markets will likely further price in tightening.