I first showed a draft of my economic data index, the Lantern Daily Economic Index (LDEI), a month ago here. Since then, its weightings, name, and index inclusions have been finalized. I will provide more information about it soon. When the LDEI correlates to yields, it suggests data dependence. When it doesn’t, it suggests something else is affecting yields and by how much.*

In the last month, economic data has fallen more than proportional 2-year yields have (gold circle in chart below.) Why hasn’t the 2-year fallen as much? I estimate the gap represents two things. First and foremost, it is the Fed’s hawkishness since their last meeting (June 12.) It was the combination of weak economic data and a dovish Fed that caused rates to fall so much last December.

I think they have been uniformly hawkish on purpose to keep financial conditions tight which encourages a more definitive “break” in the economy, which then reduces ambiguity of the U.S.’s location in the business cycle. The Fed has been reluctant to acknowledge this fourth episode of weakening economic data (blue arrows in chart below) for fear they repeat the cycle of acknowledging weakness, becoming dovish, financial conditions loosen (stocks up, yields down), which then encourages a recovery and inflation. This time, the Fed seems more determined to know if they have broken the back of inflation and the real economy before they acknowledge weakness. In other words, the bar has risen for the Fed to turn dovish.

Second, after Biden’s poor performance at the debate last Thursday, Trump’s odds to win increased, leading markets to imagine larger fiscal deficits from extending tax cuts (TCJA), tariffs, and perhaps him advocating to hold short-term rates lower than they should be. This has caused the 10-year yield to rise 15 basis points (mostly in term premium, not inflation expectations) since before the debate. The 2-year yield moved up just 3 basis points in this period because it is less connected to fiscal concerns and Trump has long-expressed a penchant for low rates. Given the weak economic data we’ve gotten in that time (consumer spending, inflation, and manufacturing ISM), presumably, 2-year yields would’ve otherwise fallen.

Yesterday, the Fed’s dynamic changed slightly. Austan Goolsbee, president of the Chicago Federal Reserve, said at the European Central Bank (ECB) Sintra Forum on Central Banking (the ECB’s version of the Jackson Hole Conference),

“If employment starts falling apart or if the economy begins to weaken, which you’ve seen some warning signs, you’ve got to balance that off with how [much] progress you’re making on the price front. The unemployment rate is still quite low, but it has been rising.”

While subtle, this is the best acknowledgement of weak economic data I’ve heard from the Fed since before the last meeting. The gap between the 2-year yield and the index represents a dam, where if economic weakness continues beyond what the Fed can ignore, 2-year yields will rush lower to close the gap. A weak jobs report this Friday could do it.

* ”How much” is more evident when the Fed is paused with no bias. When the Fed is raising or lowering rates or, is giving forward guidance, it isn’t as clear.