US Bond Market: Yellow lights are flashing – BBH

Research Team at BBH, suggests that the bonds remain heavy despite a weak spate of data that would seem to remove nearly any chance that Fed will hike rates next week.  

Key Quotes

“The implications of the disappointing retail sales data indicates that estimates for Q3 GDP will be revised lower.  

This quarter does not seem to be the breakout that had appeared to be the case previously.  The output from industrial sector, which accounts for a little less than GDP fell in August, and the July gains were shaved in revision.  

There were reports that might have blunted the negativity, but they seem overshadowed by the other reports.  Both the September Philadelphia and Empire State Fed surveys, which are part of the first readings the market receives for a new month, showed serial gains that exceeded expectations.  The US economy is still snapping the nine-month below trend growth period, but it is not doing it with a punctuation point.  

Our calculations suggest that the September Fed funds futures has about an 11% chance of a hike discount.  The CME, where the contract is traded, estimates it at 12%.  Bloomberg's WIRP has it 18% and has been consistently running higher than the CME and our calculations over the past few weeks.  

There is a greater chance that Trump is elected than the Fed hikes rates next week.  Nate Silver's fivethirtyeight.com blog puts the odds at 37.4% currently based solely on the polls.  If one adds to its economic and historical data, the odds edge up to 38.5%.  Trump has narrowed the gap, which now stands at the smallest since late July.  

St. Louis Fed President Bullard has sketched out the idea that the economy moves in certain paradigms.  These are characterized by stable (and predictable) relationships between variables, such as unemployment and inflation.  As practitioners, we have to assume the paradigm holds in the short-term.  We think this is a broadly useful way of thinking about the economy.  

Perhaps it is what some think of as the fractal nature of the market, that these paradigms are evident in other shorter periods as well.  It is important to distinguish between noise and the normal fluctuations from the signal of a change in relationships.  The rise in yields, with long-term yields rising more than short-term yields (what bonds traders call a bearish steepening) is a yellow light flashing.  It is signaling of a potential turn in the market's reaction function.”