September in Play for Bond Traders as Goldman Sees 40% Fed Odds

(Bloomberg) -- A September interest-rate increase by the Federal Reserve, an unthinkable move just two months ago, is now very much on the table, according to Goldman Sachs Group Inc. The bond market concurs.

Benchmark two-year Treasury yields reached the highest since early June after Fed Chair Janet Yellen said in a speech Friday that the case for tightening policy has strengthened. Traders’ conviction only grew after Vice Chairman Stanley Fischer said in an interview that her remarks leave open the possibility of a September hike. The market-implied chance of a boost when the Federal Open Market Committee meets next month rose to 42 percent, from zero in late June after the U.K. vote to leave the European Union.

September in Play for Bond Traders as Goldman Sees 40% Fed Odds

Yellen’s remarks “raised the odds of a rate increase at the September FOMC meeting," Goldman Sachs economists led by Jan Hatzius wrote in a note the primary dealer published Friday. "We have increased our subjective odds of a hike at next month’s meeting to 40 percent from 30 percent previously."

Yields on two-year notes rose 10 basis points this week, or 0.1 percentage point, to 0.84 percent, according to Bloomberg Bond Trader data. The weekly leap was the steepest since May.

History as Guide

With traders ramping up bets on a 2016 rate boost, shorter maturities trailed longer-dated debt. As a result, the extra yield that 30-year bonds offer over five-year notes shrank to 1.05 percentage points, the smallest since March 2015.

History suggests that a Fed rate increase supports longer-maturity bonds more than short-dated obligations. Typically, when the Fed has raised rates over the past four decades, betting longer-term securities would outperform short-term debt has proven a winner, data compiled by Bloomberg show. Higher rates help stem inflation and keep the economy from overheating.

Yellen’s speech followed weeks of conflicting economic data that whipsawed investors trying to predict the Fed’s path. Many took to the sidelines. Coming into Friday trading, 10-year yields were stuck in a range of 15 basis points this month, the narrowest span in a decade.

Futures also indicate a 65 percent chance the central bank will raise rates by December, according to data compiled by Bloomberg.

The Fed chair’s speech puts the spotlight on next week’s August labor report, which is projected to show the economy added 180,000 jobs, following a gain of 255,000 in July.

"The Fed remains totally data-dependent, and we’re getting some important data in intervening days before the third week of September," said Christopher Sullivan, who oversees $2.3 billion as chief investment officer at United Nations Federal Credit Union in New York. "It’s possible if the data is strong enough, particularly the September jobs report, the Fed will hike again."