Macroeconomic Update: Fed Shifting to Easing Mode as Inflation and Labor Market Cool

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

Economic conditions have been in a sweet spot recently, with solid real gross domestic product (GDP) growth, a labor market cooling toward a more sustainable pace even with layoffs remaining very low, and inflation arguably already back under the Fed’s 2 percent target (see for example core PCE inflation over the last six months). Whether by design or just good luck, the most acute negative impacts from the Fed’s tightening were largely cushioned by expansive fiscal policy in 2023. Meanwhile, inflation managed to cool significantly despite solid—but slowing—aggregate demand because the supply side showed rapid improvement, including both from international supply chains and expansion of the labor force.

As we look to the rest of 2024, the market seems to be extrapolating that this positive confluence of economic forces will continue to strike a perfect balance. That is a real possibility, particularly with the Fed making a more dovish shift and the associated easing in financial conditions taking some pressure off the economy. But in our view the long list of macroeconomic risks is underappreciated.

Chief among these risks is a further cooling in demand that transitions the economy from a gradual slowdown to an abrupt downshift. Job growth has been narrowly concentrated in just a few industries and could weaken further, especially now that the length of the workweek has been reduced aggressively. We also worry that the aggregate economic data are hiding stress under the surface in areas like small businesses, small banks, low-income consumers, and commercial real estate. We expect stress in these areas, many of which lie outside public markets, will stay relatively contained, but we are on watch for spillovers. And while not our base case, a risk in the other direction is that progress on inflation stalls or even reverses, whether due to new supply or commodity price shocks (increased shipping costs or higher oil prices from Mideast tensions come to mind) or demand not cooling enough.

The economic outlook has gotten more positive now that further Fed hikes are off the table and broad financial conditions are easing as substantial rate cuts are priced in. But with markets priced for such a benign outlook, we continue to expect volatility as risks of something upsetting the favorable growth-inflation mix remain elevated.

—By Matt Bush and Maria Giraldo

Important Notices and Disclosures

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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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