The Inaugural Rate Cut

It could be a momentous week for U.S. monetary policy. The Federal Reserve (Fed) is expected to cut its policy interest rate for the first time in 10 years on July 31, the last day of its next policy meeting [Figure 1].

The Fed has strongly hinted toward a rate cut at this meeting, even prepping investors for this decision with a language shift at its June meeting. Still, this is uncharted territory for much of Wall Street, as well as the current set of Fed central bankers.

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Setting the Stage

These next two weeks are pivotal for the global economy. The Federal Reserve’s (Fed) next policy meeting starts June 18 with a policy announcement due June 19. In the following week, global leaders will convene at the G-20 Summit in Japan, and we’ll likely get clues on the state of the U.S.-China trade talks.

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A Record-Long Expansion

The economic expansion just turned 10 years old, tied for the longest on record, according to the National Bureau of Economic Research. It’s only fitting with this milestone that economic skepticism is peaking once again. Many investors, especially in the bond market, have been bracing for an economic slowdown and calling for Federal Reserve (Fed) intervention as global trade disputes rattle financial markets [Figure 1].

The trade situation is unnerving, and we’re aware an escalation could eventually wear on an aging expansion. It’s important to remember, though, that with sound fundamentals and a measured Fed, the U.S. economy has navigated several global crises in this cycle. We think both supportive factors are still in place.

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The Baffling Bond Market

The bond market has been baffling recently. While U.S. stocks surged earlier this year, the 10-year Treasury yield quietly crept lower, puzzling market participants as the typical relationship between stocks and bonds (higher stock prices, higher yields) broke down at a rapid pace.

Then, the alligator jaws snapped shut. The S&P 500 Index has dropped about 6% since reaching a record high on April 30, and the decline of long-term government bond yields across the globe picked up speed [Figure 1]. Last week, the 10-year yield posted its biggest weekly drop in over four years to close at a 20-month low of 2.12%, and parts of the yield curve have flipped back into inverted territory (long-term rates falling below short-term rates).

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Five Forecasters: Few Warning Signs

It’s been a difficult year for Wall Street forecasts. The Federal Reserve’s (Fed) pause and global uncertainty have forced many economists and market prognosticators to adjust their 2019 predictions. LPL Research is in that camp, too: We adjusted a few of our 2019 economic and fixed income forecasts in February.

Near-term forecasting has been a futile effort this year, thanks to headline risk from trade and political headwinds. However, our Five Forecasters (in the Recession Watch Dashboard), which measure the longer-term health of the economy and financial markets, point to a continued economic expansion. This week, we’re highlighting two of the five leading indicators we watch: the Conference Board’s Leading Economic Index (LEI) and the U.S. yield curve. For analysis on the other three indicators, check out this week’s Weekly Market Commentary and today’s Macro Market Movers Blog.

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A Step Back On Trade

Investors aren’t quite out of the woods yet with trade tensions. On May 5, President Trump threatened to raise tariffs to 25% (from 10%) on $200 billion in Chinese imports, surprising investors who thought the United States and China were close to a deal just a few weeks ago. Five days later, the U.S. announced it would impose higher rates on that swath of goods, and China announced its own tariff increase on $60 billion in U.S. goods. Now, the U.S. is considering higher tariffs on all Chinese imports.

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The Power of Productivity

Recently, the U.S. economy has shown resilience in powering through political and trade noise. One of the most encouraging reports of late was on productivity (output per hour worked) among nonfarm employees. First quarter productivity rose at the fastest year-over-year pace since 2010, while unit labor costs grew at the slowest pace since 2013.

Growth in productivity is a key part of our economic outlook. Higher productivity boosts both consumer and corporate well-being, feeds into gross domestic product growth, and helps promote healthy inflation. A resurgence in productivity could provide the U.S. economy a timely boost, especially as many wonder what could extend this near-record expansion [Figure 1].

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A High Bar for Lower Rates

Once again, the Federal Reserve (Fed) and the markets are at odds with each other. The Fed announced it would keep rates unchanged at the conclusion of its most recent policy meeting on May 1, and Fed Chair Jerome Powell delivered comments that mirrored what he’s said for the past few months.

Still, bond markets are staunchly positioned for a lower fed funds rate, even as economic data have shown signs of recovery. Fed fund futures are pricing in more than a 50% chance of a rate cut in 2019, and short-term yields have dropped below the upper-bound fed funds rate for the first time this cycle. While investors are literally buying into this possibility, we see the Fed’s continued pause as the most prudent approach [Figure 1].

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First Quarter’s GDP Surprise

We’ve finally closed the book on what was one of the most perplexing quarters of this expansion. In January and February 2019, economic data took an unexpected turn as trade and political headwinds weighed on global demand. Tensions then subsided in March, and signs of a rebound started to appear.

These past few months have been full of surprises, so it was only fitting that this chapter ended with a blowout gross domestic product (GDP) report. The April 26 report showed first quarter GDP increased 3.2%, the best first quarter gain since 2015 and above all Bloomberg forecasts for growth [Figure 1].

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Green Shoots On Main Street

We’ve talked a lot about green shoots in the U.S. economy recently. A slew of recent data has pointed to a rebound in growth from a disappointing first quarter hampered by global headwinds. Last week, we gathered more clues on a potential recovery from an uptick in business sentiment in the Federal Reserve’s (Fed) Beige Book [Figure 1].

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