Bonds have increasingly signaled that Federal Reserve (Fed) policy may be too tight for an economy tied up in a drawn-out trade dispute.
As shown in the LPL Chart of the Day, “Bond Market Increasingly Pricing in Rate Cuts,” fed fund futures are now pricing in almost three rate cuts by the end of 2019.
The 2-year Treasury yield, another gauge of policy expectations, has fallen to about 60 basis points (0.60%) below the upper bound fed funds rate.
On balance, economic data still appear sound. However, there have been signs that growth could slow over the coming quarters.
“Trade uncertainty may be the primary risk to an otherwise solid economic outlook,” said LPL Research Chief Investment Strategist John Lynch. “Eventually, the Fed may have to intervene by lowering interest rates, which investors should view as a course correction rather than a decision to get ahead of an imminent recession.”
A course correction, or rate cut after policy tightening, has been more typical than what recent history shows. In the last economic cycle, the Fed’s first course correction didn’t occur until about four months before the recession started in January 2008. In every other expansion since 1970, however, the Fed has made at least one course correction in the first half of the cycle.
Wall Street’s favorite analogy for this environment is the 1995 “insurance cut,” when the Fed cut rates by 25 basis points (0.25%) twice that year amid fears of overtightening. At that point, the expansion was four years old, and growth was moderating (but still solid). After the Fed’s first cut in July 1995, the expansion lasted almost six years longer. Six more years for this expansion would be a surprise, but we see several similarities now to the environment that existed during the 1995 rate adjustment.
For more of our thoughts on Fed policy, check out this week’s Weekly Economic Commentary.
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