It could be a momentous week for U.S. monetary policy and the Treasury yield curve.
The Federal Reserve (Fed) is expected to cut its policy interest rate for the first time in 10 years July 31. As shown in the LPL Chart of the Day, Investors Brace for a July Rate Cut, fed fund futures are pricing in an 80% chance of a 25 basis point (0.25%) cut and a 20% chance of a 50 basis point (0.50%) cut.
“Fixed income markets have priced in an especially accommodative Fed going forward, a signal that monetary policy may be too tight for a slowing economy hampered by a drawn-out trade dispute,” said LPL Research Chief Investment Strategist John Lynch.
Gauging the impact of a rate cut on the fixed income market could be difficult. On one hand, lower rates lead to loosened financial conditions, which could boost sentiment and increase appetite for riskier assets, as we highlighted in our Weekly Market Commentary: Riding the Wave…For Now. Lower rates should also help stoke inflation, which has steadily declined this year. All of these dynamics point to the potential for higher long-term Treasury yields.
Still, the global rate environment is pressuring U.S. yields. Sovereign debt yields around the world have dropped into negative territory, and even lower rates could be ahead as the European Central Bank eyes more accommodation. Even if the Fed opts for more rate cuts down the road, global central banks may counter with even looser policy, potentially pushing more yield-hungry investors into U.S. Treasuries.
In the near term, a rate cut and appropriate Fed messaging could provide a nice pop for the 10-year Treasury yield and a path out of yield curve inversion (or long-term rates below short-term rates). We also believe the 10-year yield could push higher over the next 12 months as solid economic fundamentals prevail over global uncertainty. This forecast hinges on a U.S.-China trade resolution, though, and the jury is still out there.
For more of our thoughts on the upcoming Fed meeting, check out our latest Weekly Economic Commentary: The Inaugural Rate Cut.
Please see the Midyear Outlook 2019: FUNDAMENTAL: How to Focus on What Really Matters in the Markets for additional description and disclosure.
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