Payden & Rygel: Economics Forecast
A geopolitical crisis and oil price shock have reverberated through markets in recent weeks. We stand by our view that geopolitical events have short-lived market impacts.
Interestingly, though risk markets have recovered, as exemplified by the S&P500 retracing its war-driven drawdown and credit spreads retracing from their wides, global interest rates remain elevated relative to the end of March, and bond markets in several developed economies are signaling that central banks will hike interest rates soon. Is the bond market’s pricing justified? While we’ve made subtle shifts to our macro outlook since March, we continue to disagree with bond market pricing in several areas.
First, we now expect a flat US unemployment rate (4.3%) for the year, compared with a prior expectation of 4.6% by year-end. The change reflects annual revisions to government data released in March that show near-zero labor force growth driven by an aging population and declining immigration. Since job growth must exceed labor force growth to keep the unemployment rate steady, new data suggest the breakeven rate is lower, maybe as low as 10k/month in 2026. In turn, the recent pattern of monthly job readings alternating between positive and negative prints may not signal a deteriorating labor market.
Second, and as a result of a lower US unemployment rate forecast, we’ve lowered our recession probability from 30% in March to 20% in April. That said, given the narrow breadth of job growth and falling hiring rate, we continue to think that downside risks to the labor market outweigh the upside, so our recession scenario probability remains elevated compared to the historical average of 10%.
Third, we’ve slightly raised our US year-end inflation forecast, not because of the oil shock but more due to lingering tariff-related price pressures. In turn, as tariff passthrough to goods prices takes longer to roll off, we think year-over-year core PCE inflation will hover around 3% through the summer before moderating to 2.4% in December 2026, driven by continued disinflation in nonhousing services and housing services. In particular, even though the labor market is not as weak as we previously expected, it is far from overheating as it was in 2022, and moderating wage growth should eventually drive a moderation in nonhousing services inflation, which has been stickier than expected.
Fourth, we see a slightly higher likelihood of a productivity boom scenario. A long-term implication of near-zero employment growth is that potential GDP growth could be structurally lower, since most of the potential growth will need to come from productivity growth. We’re optimistic about the prospects for AI-driven tech investment to fuel productivity in the short run, but the historical record makes us skeptical that the productivity boom will continue in the long run if employment growth remains near zero.
Fifth, we still expect the Fed to cut three times over the next 12 months, but the timing of cuts will be further out, as core inflation will be elevated through the summer. However, as core inflation moderates toward the end of the year, we expect the Fed to cut rates twice in Q4 2026 and once more in early 2027. In turn, we still think 10-year Treasury yields will fall, but rates are likely to hover through the summer with elevated inflation and the Fed on hold. The Fed Chair nominee, Kevin Warsh, appears to share many of our macro views, but he is just one member of a 19-person committee, and his confirmation alone will not alter our view of monetary policy.
Sixth, beyond the U.S., we would push back against market pricing for rate cuts in several regions, including the euro area, Canada, and the UK. In particular, we think the Bank of England won’t deliver either of the two hikes priced in for the next 12 months, as the UK labor market has been shedding jobs on average in the last eight months. An already weakening economy suggests the growth drag from higher energy prices will outweigh the inflation push.
Seventh, credit is still set to outperform in our base case and in a slow disinflation scenario. In our base case, credit spreads will remain tight, and lower rates across the curve will boost returns on top of higher coupon returns. In a slow disinflation scenario, while rates may rise moderately as the Fed stays on hold, tight spreads and high starting yields will boost credit returns relative to cash.
The bottom line is that subtle shifts in our macro outlook do not yet call for substantial changes to our rates and credit outlook.
