Episode 57: Post-FOMC Action Plan…and Other Macro Themes
U.S. Economist Matt Bush and Investment Strategist Maria Giraldo discuss the macro and market implications of the Fed’s decision to cut interest rates. They also provide commentary on the latest issue of Quarterly Macro Themes.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, Head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. Now, as we come to the end of the third quarter, the main event for all market participants has been the lead up to the September 18th FOMC meeting and the rate decision by the Federal Reserve. Now, the decision to reduce the fed funds target range by 50 basis points begs many questions, not the least of which is what comes next for the fight against inflation, where we are in the economic cycle, what's next for monetary policy, and what does it mean for investors? Lucky for us, we have two of the leaders of our macroeconomic research and market strategy group here, Matt Bush and Mario Giraldo, to talk to us all about it. The conversation will be organized around our third quarter Quarterly Macro Themes, which we posted this week on our website at GuggenheimInvestments.com. You can find a link to it in our show notes. So with that, welcome back Matt and Maria and thanks for taking the time to chat with us today.
Matt Bush: Great to be back on Jay.
Maria Giraldo: Always happy to be here.
Jay Diamond: Matt, let's start with your thoughts on the Fed decision last week and how it factors into our outlook. First of all, what was the decision?
Matt Bush: The decision, as you said, was to reduce rates by 50 basis points in what Chair Powell called a good, strong start to a process of recalibration. And the Fed made it clear that concerns about the labor market slowing down are now overtaking inflation concerns, signaling 200 basis points of rate cuts through the end of next year. And importantly, I think their decision to move 50 basis points at this meeting showed a willingness to be flexible and respond proactively to downside risks in the economy.
Jay Diamond: What are the risks now that the Fed is facing as it tries to achieve what it always tries to achieve, which is a soft landing?
Matt Bush: Until recently, the risks of a soft landing were that inflation would prove sticky, but the Fed's language confirmed what markets have been saying for a few months now, which is that the greater risk of the soft landing is now unemployment moving higher and a recession unfolding. And so that's what they're responding to by starting off with the 50 basis point move. Of course, inflation picking back up is always a risk and it's why some of the Fed probably would have preferred a 25 basis point move, but in our view and I think what Chair Powell is view is the inflation outlook seems pretty benign right now. And so with these unemployment risks predominating, it means there's a downside bias to the interest rate outlook.
Jay Diamond: So, how does this factor into our House view on Fed policy going forward?
Matt Bush: We think in this initial stage of recalibration where rates are clearly above what is needed right now, the Fed will move pretty swiftly. So in our view, that means 25 basis point rate cuts at the next four consecutive meetings. And if the labor market shows more weakness, those 25s could pretty easily turn into 50s. As we get rates down closer to, say, 4 percent, we expect the Fed will proceed a bit more cautiously if the economy's holding up okay because around that level, we start to get into where estimates of the neutral rate are, which is really uncertain right now. And so, they'll feel the way around once we get to the 3 to 4 percent range. Ultimately, we think they get rates down to 3.25 to 3.5 percent, which is where our estimate of neutral is and where the Fed's estimate is closing in on, but just as importantly, the risks around our baseline outlook are asymmetrically to the downside. There's a meaningful probability that unemployment keeps going up, and the Fed needs to go from taking policy to neutral to taking policy to a more stimulative level.
Jay Diamond: So, Maria, how did the markets react to the decision, and what do you think all this might mean potentially for fixed income market performance going forward?
Maria Giraldo: Well, despite some of the clear downside risks in the data, markets viewed the Fed rate cut as pretty risk friendly. If you look at how the market pricing for Fed rate cuts on a month-by-month basis in 2025 shifted from pre-FOMC to post-FOMC, it suggests to us that there was some marginal decline in recession probability. And I think that's in reaction to Powell striking a good balanced tone at the FOMC press conference. So, rates didn't move too much because the market had already priced in the long easing cycle. And because of this, risk assets viewed the press conference very favorably as well as we are starting to see a little bit more of stabilization and long end rates. The S&P 500 hit on a new all-time high, the Russell 2000, so representing small caps had its best week since July. Spreads tightened and are back to really tight levels relative to history. Just before we started this conversation, I saw that both BB and B corporate bond spreads are under 7th percentile of historical levels, meaning they've only been tighter 7 percent of the time going back to the mid-90s. So, what this is telling us is that the market believes rate cuts will relieve pressure on smaller companies that have been disproportionately affected by both rate hikes and inflation.
Jay Diamond: So, a lot of the themes have to do with what you mentioned, Maria, which is the recession probability that's being factored in, because that's a very important variable when it comes to thinking about how assets are going to perform in a rate easing environment. So, let's start off with the first theme here, Matt, which is called “Growing Risks from the Labor Market”. So, it's in here because, as we know, your team believes that the labor market is a bellwether for the future of the U.S. economy and for Fed policy. So, summarize what you wrote in this theme and the main takeaway.
Matt Bush: Even more so than usual, there's been a lot of focus on the labor market recently, and a wide range of arguments about how to interpret it. On the one hand, you have these big downward revisions to the jobs numbers, the triggering of the so-called Sahm Rule that argues a recession is likely at this point. But then, on the other hand, you look at data like initial jobless claims, and it shows layoffs remain very subdued. So, the point of this theme is try to square that data. And the key dynamic we think, is that while layoffs are indeed low, we're still seeing a growing pool of unemployed workers, and that's because hiring activity has slowed a lot. So, for the workers who are laid off or for those newly entering the labor force, it's becoming harder and harder to find a job, and that's worrying because these unemployed workers are obviously earning less and spending less. And because the slowdown in hiring is usually something that precedes recessions. Layoffs staying low is a positive, of course, but there have been recessions in the past where layoffs didn't pick up until the recession was already underway. So, it's encouraging for what has gone on recently, it's not as encouraging on a forward-looking basis. So, the takeaway we have from this section is that we don't think a recession is inevitable at this point, but current trends in the labor market are worrying. We think the Fed needs to act boldly and bring rates down to stimulate more hiring activity and prevent unemployment from spiraling higher. And in that regard, the 50 basis point rate cut in September was a good start to that process, but we think it will take more.
Jay Diamond: Now, the Fed isn't the only game in town. There's also fiscal support from the government. And the second theme in the Quarterly Macro Themes is titled “Massive Fiscal Support of Growth Is Waning”. So, Matt, a big question for market participants is whether this cycle happens within the context of recession. So how does this theme fit into the calculation?
Matt Bush: Sure. So, this theme on fiscal policy points out that the direction of fiscal policy is likely to slow growth going forward. Not necessarily into recession, but the direction of travel is clear, to borrow a phrase from Chair Powell. It's pretty widely acknowledged that fiscal policy played a really important role in limiting economic damage from the pandemic in 2020. I think what's less recognized is how long some of those Covid-era programs have continued to be felt in the economy. And this theme points out that there are several reasons to think fiscal policy will slow growth going forward. We have federal government spending slowing down at the top line level, but then we have some of these programs, like Covid-era Medicaid enrollment falling as eligibility rules change. We have pandemic era education funding also expiring, and we're seeing state and local governments who benefited from pandemic federal government fiscal transfers also signaling pretty meaningful declines in their spending over the next year. This particularly matters because governments and the related health care sector that receive support from the government have been big drivers of GDP growth and job growth recently. About 40 percent of GDP growth over the past year, and about three quarters of job gains have been from the government and health care sectors. So, a loss of momentum in this part of the economy will have a meaningful impact in aggregate, and it's likely to raise market and Fed concerns about a slowing economy. Obviously, the election can and will alter the policy outlook, but we think given the time to debate and implement new policies, it'll be 3 or 4 quarters before election impacts are felt. So, for the time being, again, the direction of travel is for fiscal policy weighing on the growth outlook.
Jay Diamond: And Maria, are there any municipal, corporate or consumer credit components to fiscal policy that investors should be aware of?
Maria Giraldo: There are several credit-related or sector-related considerations for investors that are related to fiscal policy. First, fiscal policy decisions can have a broad impact on interest rates, and that affects all types of bonds, including munis and corporate bonds. Now, we've seen this play out a couple of times, at least in recent years, where the bond market sold off, and interest rates spiked because investors didn't like something they saw in the fiscal picture. When you have these sort of sharp increases in interest rates or interest rate volatility, it can really ripple through broader financial conditions. It could harm confidence, put some downward pressure on economic growth, and then more directly, as we're kind of thinking about the effect of government spending -- government spending can affect demand for goods and services, which impacts corporate revenues and their ability to service debt. So, Matt's talking about some of these channels shutting off potentially. We will also have to think about kind of what the reaction might be if it shuts off too much and slows growth too much, and then policymakers are reacting. So, there's going to be sort of these shifting dynamics as we go through the next couple of years. On the consumer side, you want to think about the way that fiscal policy influences spending and borrowing behavior. For instance, tax cuts or stimulus payments can increase disposable income. It can affect consumer credit demand -- you can imagine how that flows through to the banking system, and it can flow through to sectors that are generally financed or borrowing, like the housing market or the auto market. And in the corporates, we're really keeping an eye on in particular some of the tax policy adjustments that might come in the next couple of years. There are several provisions of the Tax Cuts and Jobs Act from several years ago that are due to expire in 2025, and they were pretty favorable for small companies. So, we can see these types of fiscal policy shifts that affect how investors view corporate credit, whether it's favorably or if it's kind of tightening financials for a lot of companies. So, definitely a lot of reasons investors should keep an eye on these dynamics.
Jay Diamond: So, it's almost as if monetary policy is easing, but fiscal policy is tightening.
Matt Bush: That's exactly right. And in our view, the fiscal dynamic for the near term is likely to predominate. It tends to work more quickly on the economy. Monetary policy famously works with long and variable lags. And so, we do think they'll be a positive impact from Fed easing, but it'll take some time to be felt.
Jay Diamond: The third theme in the Quarterly Macro Themes is called “The Historic Surge in Immigration Is Coming to an End”. Now, immigration is not only a hot election year topic, but it's also an economic input. So, Matt, what are we saying here about immigration, and why should investors care?
Matt Bush: So, like fiscal policy, immigration was a source of economic resilience that helped offset the tight monetary policy we had over the last two years. The Congressional Budget Office estimates 3.3 million people entered the US in 2023, which is almost triple the rate that we saw on average in the prior decade. And this wave of immigration came at a time when demand for workers was high, which resulted in a big expansion in the labor force, which arguably helped rebalance the labor market and cool the overheating we were seeing there. So, that surge in immigration was an important source of supply-side economic growth, but conditions have changed pretty abruptly over the past several months. Pressure on the Mexican government to tighten border security, along with an executive order issued in June that capped the number of asylum seekers entering the U.S., has led to a sharp slowdown in immigration. The monthly data we have shows a decline of over 70 percent since the peak in December in terms of monthly border activity. And policy is likely to get more restrictive no matter the election, given the current political environment. So, in this theme, we take a stab at estimating the macro impact of this, which we think is quite large. We estimate that non-farm payroll growth could be anywhere from 63,000 to 96,000, lower per month in 2025 relative to what immigration flows were expected to look like before the executive order was put in place. And with less labor supply, less workers producing goods and services, potential GDP growth will also be reduced. We estimate by up to a percentage point in the most restrictive immigration scenarios. Immigrants don't just impact the supply side, they also raise demand as well by spending money. So, the impact on inflation and on the unemployment rate will be smaller. But the slowdown is going to mean lower nominal GDP growth, which in turn supports the view that interest rates are headed lower.
Jay Diamond: Maria, you wrote the final theme in the QMT called “Strong Corporate Profits Suggest Still Healthy Growth”. So please summarize the theme for us, and does it leave us bullish or bearish on credit?
Maria Giraldo: Yeah, we had a couple of objectives with that piece. First, we wanted to give a quick snapshot of how corporate fundamentals look compared to historical data. I think this is especially an important question, because investors are really struggling with determining whether this easing cycle is going to be a recessionary one, or if it's not going to be a recessionary one, or if it's going to be a soft landing. And so I think seeing where corporate fundamentals are starting off in either scenario might help give investors some confidence around how they're positioned in their portfolio. So, on the fundamental side, things generally look healthy. We think they look healthy. When we look at the big picture, using data from the Bureau of Economic Analysis, which aggregates corporate profits and other measures at a very system-wide level, we see that leverages around average interest coverage is very healthy and profit margins are robust. When you zoom in on high yield corporate bonds, we'd say pretty much the same thing. And then for investment grade bonds, leverage is a bit higher than the 20-year average, but interest coverage is still well over ten times. So, it's not really an area where we're worried about credit risk right now in investment grade. We might see some net reading migration that's a little bit more balanced going forward -- a few more downgrades, than upgrades -- but that's kind of a bit of a minor point, and we still see plenty of opportunity there. The other objective was also to look at profit growth, and it's strong, using high level data from the again, the Bureau of Economic Analysis, after tax, corporate profit growth was about 11 percent in the second quarter, which is quite a turnaround from the contraction we saw last year. But there's an important caveat to this data and that it can be revised on a historical basis. So, we need to be a little bit cautious about extrapolating recent trends too far into the future. If you look back at data releases around previous recessions like 2000 and 2007, or earlier recessions in, most investors might have thought we were headed for a soft landing because profit growth at the time said it was more like over 5 percent year-over-year, sort of a not too hot, not too cold outcome, but subsequent revisions to that data show it was actually much weaker, below 2 percent and even negative shortly after. So again, that soft landing picture investors may have had in real time wasn't exactly accurate. So, your question is where does that leave us? Is that bullish or bearish? I would still say it's bullish because again the trajectory for corporate profit growth where it's gone from negative last year to 11 percent--plus 11 percent--this year is something that looks very different from history. But I would just say again, where we are today is in giving us a forecast of where we might be next year. So, you kind of still have to look at the data, take it with a grain of salt, and try not to be too overconfident in how we're forecasting what the credit picture will look like next year.
Jay Diamond: We've covered a lot of territory. I think it's a terrific issue of the Quarterly Macro Themes. What takeaways would you like to leave with our listeners after having been with us for this podcast?
Maria Giraldo: As I alluded to earlier, investors are struggling with this idea of whether we're going into a recession or not, whether the Fed has achieved a soft landing, and what does rate cuts mean for the market. One thing that we didn't cover is that in our publication, in the intro chart, we show this bar chart that shows that high quality fixed income historically has performed well in either scenario, whether it's a recession near easing cycle, a non-recessionary easing cycle. So, we think that this is still a great time to position accordingly. There's still opportunity in high-quality credit. There's still a lot of yield advantages that areas like investment grade corporates and structured credit provide to portfolios. The history does suggest that both outcomes would be favorable for portfolios. As we think what the market is going to look like over the next year or so as the Fed delivers those rate cuts, would investors need to kind of keep an eye on is that front end rates are going to come down. 3-month T-bills and all the kind of shorter-term rates where investors may have exposure to right now, maybe they have money market allocation. All those yields are going to come down very gradually. And though it's not guaranteed, the fixed income market may capture some of the outflows that happened in some of those other spaces as investors look for opportunities to lock in those yields. So, I think this is still a good time for fixed income, especially if the Fed manages to achieve that soft landing, and the outlook is pretty bright for credit.
Jay Diamond: Great. Well, thanks again for your time. Matt and Maria. I hope you'll come back and visit with us again soon so we can compare notes on on how the outlook fared. And thanks to all of you who have joined us for our podcast. If you like what you're hearing, please rate us five stars. And if you have any questions for Matt, Maria, or any of our other podcast guests, please send them to macromarkets@Guggenheim investments.com, and we will do our best to answer them on a future episode or offline. I'm Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, including the latest Quarterly Macro Themes, visit Guggenheim investments.com/perspectives. So long.
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