The Fed Is Leaning into the Fiscal Boost

Above-potential growth, a tight labor market, and rising inflation mean Fed policy is heading into restrictive territory.

August 23, 2018

This Macroeconomic Outlook sector report is excerpted from the Third Quarter 2018 Fixed-Income Outlook.

The U.S. economy had a stellar second quarter, with real GDP growth accelerating to 4.1 percent annualized. As we expected, fiscal easing is boosting growth further above potential, which we estimate to be just 1.5 percent. While growth should moderate in the third quarter, government spending will support the economy in the quarters ahead. Nevertheless, our research still indicates that a recession is likely to begin around early 2020.

With growth above potential, the labor market is on track to overheat. Trend payroll growth remains roughly two times its sustainable rate, consumer and business surveys point to increasingly tight labor conditions, and job openings exceed the number of unemployed workers to fill them. This has driven an acceleration in wage growth, with private-sector employee compensation costs rising 2.9 percent in the second quarter of 2018, up from an average of 2.0 percent from 2012–2015.

Inflation stands at the Fed’s target, with core personal consumption expenditures (PCE) running at 1.9 percent year over year. Given the 18-month lag between GDP growth and core inflation, strong growth should nudge up inflation through 2019, particularly given recently enacted import tariffs. Given the U.S. administration’s threats of much broader tariffs, near-term inflation risks are skewed to the upside.

We have long argued that the Fed’s policy stance will turn restrictive in 2019 in order to slow economic growth and job creation to more sustainable rates. Fed policymakers now agree, with nearly all Federal Open Market Committee (FOMC) members projecting in June that rates at end-2019 will be above their respective estimates of neutral. On average, policymakers expect rates to be 0.5 percent above neutral by end-2020. The market either believes that the neutral rate is lower or it is skeptical that the Fed will get restrictive, with just three hikes priced in for the rest of the hiking cycle. We expect six hikes, like the Fed, but we see them all happening before the end of 2019. Restrictive Fed policy is coming.

With economic growth unsustainably high, the labor market tight, and Fed policy heading into restrictive territory, it is natural for the Treasury yield curve to flatten. We are positioned for further bear flattening toward our 3.25–3.5 percent terminal fed funds rate projection over the next year, implying a roughly 50 basis point increase in 10-year yields from here. We maintain low credit exposure as we see an unfavorable risk/reward tradeoff given tight spreads, escalating trade tensions, and a recession approaching in 2020.

U.S. Economic Growth Accelerated in Q2 as Fiscal Easing Kicked In

Real Gross Domestic Product

Real GDP growth accelerated to 4.1 percent annualized. As we expected, fiscal easing is boosting growth further above potential, which we estimate to be just 1.5 percent.

U.S. Economic Growth Accelerated in Q2 as Fiscal Easing Kicked In

Source: Haver Analytics, Bureau of Economic Analysis, Guggenheim Investments. Data as of 6.30.2018.

FOMC Sees Rates in Restrictive Territory by End-2019

On average, the FOMC expects rates to be 0.5 percent above neutral by end-2020, implying six more hikes. The market either has a lower estimate of neutral or it is skeptical that the Fed will get restrictive, with just three hikes priced in for the rest of the hiking cycle. We expect six hikes before end-2019.

FOMC Sees Rates in Restrictive Territory by End-2019

Source: Federal Reserve Board, Haver Analytics, Guggenheim Investments. Monthly data as of 7.25.2018. Note: FOMC projections are interpolated based on yearly forecasts in the June 2018 Summary of Economic Projections.

—Brian Smedley, Head of Macroeconomic and Investment Research; Maria Giraldo, CFA, Managing Director; Matt Bush, CFA, CBE, Director

Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-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 risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management. ©2018, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


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