For 2024, we foresee several crosscurrents that could influence the outlook for US growth and inflation. Before we discuss those, let’s look at the demand and supply-side factors behind the remarkable resilience of the US economy in 2023.
The robustness of corporate and household balance sheets supported consumption and investment, while a strong employment market and real wage gains lifted confidence among US consumers. The CHIPS & Science Act and Inflation Reduction Act provided subsidies for business investment in microchips, technology, infrastructure, electric vehicles and energy transition projects.
Artificial intelligence (AI) investment boomed as firms sought to develop and exploit the new technology’s potential. Supply chain disruptions from the pandemic continued to ease, removing constraints to production. Prime-age labour supply growth filled job openings, with prime-age participation rates climbing back to above the pre-pandemic peak.
These factors blunted the impact of the US Federal Reserve’s 525bp of rate hikes and its balance sheet roll-off efforts and allowed the economy to continue expanding above its long-run potential.
Yin and yang in 2024
We note there is a possibility that GDP and productivity growth in the US during 2023 were not actually as strong as generally believed.
One also has to be cautious about the scope for downward revisions to payrolls data given their dependence on a model which generally overestimates hiring when the economy is slowing. We have also seen some deterioration in business sentiment.
We believe caution is warranted concerning the potential for a credit contraction given the ongoing earnings issues at many regional banks. Some analysts have pointed to increased delinquency rates on car loans as evidence of consumer stress in some regions.
The fiscal picture is likely to see modest budget tightening, although we believe a significant contraction is unlikely in a presidential election year.
On monetary policy, some argue that the full impact of monetary tightening has yet to be felt and that residential construction and turnover are likely to hit be hard by affordability challenges.
On the brighter side, the apparent robustness of growth and payrolls in 2023 suggests the neutral monetary policy rate might have risen significantly and/or that the economy has become less sensitive to interest rate increases. That would suggest that the US Federal Reserve’s (the Fed) stance is not overly restrictive.
Alternatively, one might ponder whether the impact of rates might yet to be fully felt given the refinancing opportunity at low rates over 2020-2022. One may also wonder whether the dramatic loosening of financial conditions in the fourth quarter of 2023 might stimulate growth again.
Several analysts have noted that real wage growth turned positive in 2023 as wages outpaced prices. Correspondingly, real household incomes could yet prove strong in 2024; combined with the wealth effects of the recent equity market surge, this could support consumption.
Whether this reinvigorated demand backdrop would be inflationary would depend on supply. Current tensions in the Middle East pose risks to energy prices and supply chains, potentially reversing recent improvements in the New York Fed’s Index of Global Supply pressures.
On the labour market, we should note that prime-age labour force participation seems unlikely to show the same increase in 2024 as it did in 2023; indeed, it has pulled back recently.
In a nutshell, there is no guarantee that the supply environment will be as disinflationary as in 2023, simply because supply conditions have less room to normalise.
Where does all of that leave us?
First, our baseline scenario is that we anticipate US economic growth to slow to a rate slightly below trend. This would likely generate a modest increase in unemployment, but avoid recession. At the same time, inflation should continue its gentle descent towards the Fed’s 2% target, at least in 2024.
The combination of below-trend growth, a looser labour market and falling inflation should allow the Fed to start lowering the policy rate in 2024. We expect rates to be cut by 125bp to 4.25% in 2024 and by a further 100bp to 3.25% in 2025, ending at 3.00% – our best estimate of the neutral rate.
A ‘soft landing/immaculate disinflation’ scenario is, however, already largely priced into markets. At the time of writing, markets expected around 150bp of cuts by the Fed in 2024 and a low point of around 3.2% by late 2025, leaving equities near all-time highs and corporate credit spreads tight.
The key risk to the baseline scenario is inflation. Here, the balance of risk is to the upside. Inflation should decline further. However, there are risks: supply disruptions could resume amid geopolitical tensions, wages could prove sticky (especially if growth were to reaccelerate in 2024), and even rents could be squeezed higher. Structural factors such as deglobalisation and the indirect impacts of climate change and costs of the energy transition could add to inflationary pressures.
Should this upside inflation scenario materialize, the Fed would be unlikely to deliver the full 150bp of rate cuts currently priced in, and policy rates might ultimately only fall to 4%, perhaps pushing benchmark 10-year T-note yields back up to 4.75%.
Were the economy to sink into recession amid a credit crunch aggravated by stress in commercial real estate and/or regional banks, unemployment would rise quickly, wage growth would slow sharply, and core inflation would fall to below target by 2025. The Fed would be obliged to quickly pivot to an accommodative stance, taking rates to perhaps 1.5% or 2.0%. A recession/low inflation scenario would accelerate the bond market rally and could take 10-year T-note yields to 3%.
To our mind, the sticky inflation scenario is more likely than the recession scenario over the coming months.
Portfolio strategy in the first quarter of 2024
The term structure of US Treasury inflation-protected securities (TIPS) yields appears to have value. Current 10-year TIPS yields are still at levels not seen since 2009 (see Exhibit 1). Owning 10-year yields at levels comparable to trend growth has historically been profitable. One now has to figure out whether the possibility of higher neutral rates and higher term premia means higher levels are still possible.
The other important theme for 2024 is the likely ongoing growth in supply of US Treasuries and its implications for the term premium. After massive pandemic-related deficits in 2020 and 2021, the federal deficit narrowed markedly in 2022. However, reduced revenues from capital gains taxes, smaller remittances from the Fed, larger outgoings related to the CHIPS and IRA legislation, and climbing interest costs pushed the deficit back up towards 7% of GDP in 2023.
For 2024, most economists expect only a modest correction in the deficit, to perhaps 6% of GDP, with the mix of issuance between short-dated bills and coupons favouring coupons. This raises the question of who will step up to take it up.
We also need to look at liquidation of central bank holdings that could push net supply up further. Net Treasury supply to private bondholders has been climbing faster than is implied by the federal government’s net funding needs. Also, the buyer base for US sovereign debt has shifted from official institutions towards other investor types, notably households, pension funds, insurance companies and banks. These are price-sensitive buyers.
Heavier issuance, central bank balance sheet reduction and a changing investor mix have prompted a significant rise in the Treasury term premium, steepening the 5-year/30-year rate slope. While the rally in November and December helped to re-flatten the Treasury curve, the prospect of additional heavy net supply suggests to us that this theme of higher term premia will be revisited.