US economy, Markets Policy rate uncertainty set to persist

Contradictory evidence and conflicting interpretations of economic data, asset pricing, and the outlook for Federal Reserve policy have buffeted markets in recent weeks as expectations of a soft landing for the US economy have ebbed and flowed.

On balance, we think the incoming data support our view of a “softish” landing for the US economy, i.e., inflation moving closer to the Fed’s target without a recession this year. But remaining uncertainty is likely to keep investors guessing on the Fed’s next move and keep market price action choppy:

• “Supercore” inflation remains sticky. The PCE deflator, which is the Fed's preferred inflation measure, increased a modest 0.2%month-over-month in July. However, Fed Chair Jerome Powell has been emphasizing the inflation subcategory “core services ex-shelter,” which showed a bigger 0.5% rise. And in year-over-year terms, PCE inflation rose to 3.3%, up from 3% in June. This is well above the Fed's 2%inflation target, keeping alive the possibility of another rate hike.
• A rebound in the savings rate could slow growth. US personal spending increased 0.8% month-over-month in July, coming on top of a 0.6% rise in June. On the income side, wage income was up a more modest 0.4%. With taxes and non-mortgage interest payments rising, disposable income was flat. This combination of rising spending and flat income caused the savings rate to drop to 3.5%. But households have used up most of the excess savings built during the pandemic. In our view, the current savings rate is unsustainably low, and the main downside risk to growth is that the savings rate will suddenly move higher.
• The labor market is cooling. Earlier this week, JOLTS job openings were weaker than expected, falling to 8.8 million in July, which is down from the peak of 12 million last March. The focus will now shift to August nonfarm payroll data released later today. Consensus forecasts call for a 170,000 increase in nonfarm payrolls, which would be the smallest gain since December 2020.

Our base case view is that by the time of the November FOMC meeting, the economy will have shown clear signs of slowing, leading the Fed to finally put an end to its sharpest rate-hike cycle since the 1980s. We expect US Treasury yields to fall by year-end as both US growth and inflation moderate.

Today’s high bond yields therefore provide investors with a good opportunity to lock in currently elevated rates for an extended period. In fixed income, we like opportunities in the 5–10-year duration segment in high grade (government), investment grade (including select senior financial debt), and sustainable bonds. Exposure to actively managed income strategies and yield-generating structured investments can also help investors take advantage of the breadth of opportunities.

Main contributor - Solita Marcelli, Mark Haefele, Vincent Heaney, Jon Gordon, Brian Rose

Original report - Policy rate uncertainty set to persist, 1 September 2023.