Macroeconomic Update: Fed Needs to Act to Prevent Normalization Turning into a Downturn

This Macroeconomic Outlook report is excerpted from the Third Quarter 2024 Fixed-Income Sector Views.

The U.S. has returned to conditions that look more like “normal.” The overheated labor market of 2021–2023 has seen demand for workers cool alongside expansion of available labor supply, causing the unemployment rate to drift upward from 3.4 percent to 4.3 percent over the past year and a half. Fed officials now describe the labor market as in “rough balance” and back to conditions seen before the pandemic.

Meanwhile, substantial progress has been made in bringing inflation back down to the Fed’s 2 percent target. Following a hot first quarter, recent months have seen renewed progress in the inflation fight, bringing core personal consumption expenditures (PCE) inflation down to 2.6 percent in year-over-year terms and 2.3 percent annualized in the three months through June. This inflation progress looks to be durable for two key reasons: First is the rebalanced labor market and associated cooling in wage growth. Second is the slowdown underway in shelter inflation, which has been the biggest contributor to above target inflation but which finally saw a long-awaited slowdown in the June inflation data. Leading indicators of rent inflation, particularly prices for newly signed leases, suggest this slowdown should stick and help inflation remain low for at least the next few quarters.

With the economy getting back to normal, the Fed should soon follow suit with its rate policy. Fed officials are increasingly acknowledging that if they wait too long to bring interest rates down, they risk turning this normalization into more of a slowdown, or even recession. The July employment report seemed to validate those fears just days after the Fed decided to hold rates steady at the July meeting, with the unemployment rate rising 20 basis points and job growth outside healthcare and government up just 33,000. Compounding downside risks, recession fears, questions around AI, and foreign spillovers have highlighted vulnerability to an equity-led tightening in financial conditions.

The emergence of these downside risks, which we have previously flagged, raises the risk that the normalization the Fed has been seeking turns into a slowdown, or even recession. We expect the Fed will respond by cutting rates faster than previously expected, with at least three 25 basis point rate cuts this year, and the potential for larger cuts if the labor market data continues to weaken. More importantly, we see downside risk to the terminal fed funds rate from what is priced into the market, which is conditional on a soft landing. Easing cycles are usually faster than tightening cycles, and this tightening cycle was historically fast. There is risk around market expectations of a ladder step easing.

—By Matt Bush and Maria Giraldo

Important Notices and Disclosures

This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.

This material contains opinions of the authors, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward-looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.

Investing involves risk, including the possible loss of principal. In general, the value of a fixed-income security falls when interest rates rise and rises when interest rates fall. Longer term bonds are more sensitive to interest rate changes and subject to greater volatility than those with shorter maturities. During periods of declining rates, the interest rates on floating rate securities generally reset downward and their value is unlikely to rise to the same extent as comparable fixed rate securities. Investors in asset-backed securities, including mortgage-backed securities and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.

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