Normalizing Today, Overshooting Tomorrow
A strong economy is likely to embolden the Fed to raise rates at a faster pace than the market is expecting.
The U.S. economy continues to expand at an above-trend pace. Real gross domestic product (GDP) grew at an annualized rate of 3.0 percent in the third quarter, similar to the 3.1 percent pace seen in the second quarter, despite a roughly 1 percentage point drag from several major hurricanes. We also expect fourth-quarter growth to be near 3 percent, supported by strong momentum in the United States and abroad, favorable financial conditions, and rebuilding activity in the wake of recent storms. We see potential upside risks to 2018 growth in the event that tax cuts pass in Washington.
Fed Rate Hikes Are Set to Continue as the Fed Overshoots Its Dual Mandate Goals
We expect the Fed to resume a quarterly pattern of rate increases in December, hiking four more times in 2018 as unemployment and inflation overshoot on a net basis the Fed’s dual mandate objectives.
Source: Haver Analytics, Congressional Budget Office (CBO), Guggenheim Investments. Data as of 10.11.2017. Combined dual mandate shortfall adds the deviation of core PCE inflation from the Fed’s 2 percent objective and the deviation of the unemployment rate from the CBO’s estimate of the natural rate of unemployment.
Meanwhile, the labor market is steadily tightening and is in the early stages of overheating. This is evidenced by the fall in the unemployment rate to a cycle low of 4.1 percent in October. Hurricane activity distorted payroll employment in September and October, but job growth has averaged 169,000 per month in the year through October, underscoring the robust—and unsustainable—underlying trend in hiring. Although average hourly earnings data have been noisy, other indicators of wage growth, such as the employment cost index, continue to trend higher, confirming that the wage Phillips Curve is not defunct. Leading indicators, including hiring intentions surveys, point to further declines in the unemployment rate.
Inflation continues to be well below the Fed’s 2 percent target, with core personal consumption expenditure (PCE) inflation coming in at 1.3 percent in September. However, inflation lags GDP growth by about six quarters; because growth has accelerated over the past year, and the dollar has depreciated, inflation will likely move closer to 2 percent later in 2018.
We expect the Fed to resume a quarterly pattern of rate increases in December, continuing until late-2019, as unemployment and inflation are likely to overshoot on a net basis the Fed’s dual mandate objectives. Four hikes in 2018 would be a much faster pace than the market is currently pricing in, and we expect the result to be a bear flattening of the Treasury yield curve. The rise in shorter-maturity yields should outweigh any steepening pressure coming from the decline in net demand for long-duration bonds as the Fed balance-sheet runoff ramps up and European Central Bank (ECB) tapering takes effect. The appointment of Jerome Powell as Fed Chair does not change our bear flattening view, as he is likely to continue the policy direction that is currently in place.
Net Central Bank QE Purchases Are Likely to Fall Sharply Over the Coming Year
The rise in shorter-maturity yields should outweigh any steepening pressure coming from the decline in net demand for bonds as the Fed balance-sheet runoff ramps up and ECB tapering takes effect.
Source: Haver Analytics, Guggenheim Investments. Data as of 10.30.2017. Note: Monthly rate of net bond purchases by the Federal Reserve, European Central Bank, Bank of Japan, and Bank of England at current exchange rates. QE = quantitative easing.
—Brian Smedley, Head of Macroeconomic and Investment Research; Maria Giraldo, CFA, 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. ©2017, 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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*Assets under management is as of 6.30.2019 and includes leverage of $11.2bn. 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, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC, an affiliate of Guggenheim, SI, GFIA and GPIM.
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