Are Rate Hikes Pushing Markets to Breaking Point?

MIKE TOWNSEND: Last week was another one of those dizzying weeks where the market sent investors a batch of mixed signals. The week started with the best two-day rally in stocks since April 2020, with the S&P 500® rising 5.7%. But the week ended with a sharp decline, as the markets processed another strange jobs report that saw a slowdown in hiring but also saw the unemployment rate tick down to 3.5%, tying the lowest recorded since 1969. Treasury yields spiked back up in reaction.

The roller-coaster week was just one indicator that the Federal Reserve's plan to continue its series of aggressive rate hikes isn't coming to an end anytime soon. With three weeks to go before the Fed's next monetary policy decision point, it's hard not to feel exhausted by all the news―and harder still to know where to turn for potential investing opportunities.

Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

On our last episode, we focused on the economy and the stock market with Liz Ann Sonders. On this episode, Kathy Jones, Schwab's chief fixed income strategist, is joining me to talk about what the Fed's aggressive rate hikes are doing to the bond market and the dollar and what that means for markets at home and around the globe.

But first, a quick look at a couple of the stories making headlines in Washington right now.

As expected, Congress did manage to avert a government shutdown before the October 1 deadline, passing a temporary measure that extends government funding through December 16. That bill also included $12 billion in new funding to support Ukraine in its ongoing war with Russia, as well as $1 billion to boost a low-income home-heating assistance program in advance of winter's arrival.

And the bill included $4.5 billion in disaster relief, with much of that aid focused on late summer disasters like the Kentucky floods and wildfires in New Mexico. However, the bill was approved just before Hurricane Ian wreaked devastation on the Florida west coast―so we can expect a much larger disaster relief package to be front and center on the Congressional agenda when lawmakers return to Washington after the election.

With the passage of the government funding extension, Congress is now out of session until the week of November 14. It had been expected that the Senate would return for a week or two of business this month, but Senate Majority Leader Chuck Schumer bowed to pressure from the numerous senators in tough re-election battles to spend the entire month of October on the campaign trail. So there won't be any significant legislative activity until both the House and Senate return to D.C. after the election.

But while Congress may be quiet, regulatory agencies in Washington are staying busy, and there was a notable announcement from the IRS late last week. The IRS announced that it would not enforce new rules requiring some owners of inherited IRA accounts to take required minimum distributions until 2023.

Here's the back story. In 2019, as part of the SECURE Act, Congress changed the rules for non-spousal heirs of individual retirement accounts. Under the old law, if your mom passed away and left you her IRA, you had the rest of your life to withdraw the assets in that account. But the SECURE Act mandated that children and other non-spouse heirs had to distribute the assets in that inherited account within ten years.

The way the law was written, it seemed that you could, if you wanted to, wait until nine years and 364 days had passed and then take the assets out of that account all at once. Or you could take some along the way, in whatever amount and timing you chose, just as long as the account was empty at the end of the ten years.

But earlier this year the IRS proposed regulations that would require heirs to take annual distributions in each of the ten years. And, since the law went into effect at the beginning of 2020, it meant that heirs who inherited an account that year, or any time since, were already multiple distributions behind. Making things even worse, there's a 50% penalty assessed on the amount that should have been taken out. Taxpayers complained loudly to the IRS that it had effectively changed the rules after the game had started and that they did not know that they were required to take annual distributions until the rule came out earlier this year.

Last week the IRS announced that they would not enforce the new rules until 2023. Basically, that means that anyone who inherited an IRA in 2020, 2021, or 2022 isn't responsible for the required minimum distribution for those years, and no penalty will be assessed. Beginning next year, however, the annual distributions will be required. The rule does not apply to spouses who inherit an IRA.

The IRS is arguably the least popular agency in Washington―but this time it feels like they actually got one right.

On my Deeper Dive today, I want to take a closer look at what's going on in the bond market both here and abroad. The Fed's rapid series of rate hikes has created turmoil in the bond market, and it's also impacting the dollar, which is having a ripple effect on economies around the globe and even pushing some countries toward default. To unpack everything that's going on―and to give us some advice about how to navigate these choppy waters―I'm pleased to welcome back to the podcast Kathy Jones, Schwab's chief fixed income strategist. Kathy, welcome back to WashingtonWise.

KATHY JONES: Great to be here, Mike.

MIKE: Let's begin by just getting a quick and simple explanation of what's going on in the bond market and what you think the bond market is telling us about how far the Fed will go. We know that as interest rates rise, bond prices fall. But we've never seen the Fed raise rates so quickly before―three straight hikes of 75 basis points. So, first, how has the bond market been reacting to that?

KATHY: Well, the bond market is following the Fed's actions. Short-term rates have risen in line with the guidance that we're getting from the Fed. It's pretty clear from the statements of the various Fed members that they're interested in raising the fed funds rate―the base lending rate―to about 4.0% or 4.5% in a very short period of time in order to get inflation down. And short-term interest rates like T-bills and two-year notes will tend to track the Fed's rate hikes very closely.

Intermediate to long-term bond yields haven't risen quite as much, although they've gone up a lot. With longer maturity bonds, yields tend to reflect not only expectations for the path of short-term rates, but also inflation expectations longer term. When the Fed tightens policy aggressively, as it is now, it's not unusual to see longer-term rates lag behind because the signal is that rate hikes will slow the economy and bring inflation down. And that's what we're seeing. In fact, long-term yields are now lower than short-term yields―what we call an inverted yield curve. Two-year yields are in the range of 40 to maybe 50 basis points higher than 10-year yields. That's something we don't see very often, and it's often associated with recessions.

MIKE: So Kathy, did I hear a prediction there? Recession is obviously a word on everyone's mind. So do you think we are headed into a recession―or maybe we're already in one?

KATHY: Well, there's certainly a lot of signs pointing in that direction. So GDP growth, or gross domestic product growth, was flat to negative in the first half of the year. Manufacturing and housing, which are very sensitive to interest rate changes, are slowing down, and the leading economic indicators have fallen for six consecutive months. These are things we typically see when we are entering or in a recession. However, the job market still looks pretty healthy, and that's supporting consumer spending. This could be what is often called a "growth recession" by economists, but the risk is it develops into a sharper downturn as long as the Fed is still raising rates.

MIKE: With the Fed continuing to be in tightening mode, how far does the bond market believe the Fed will go?

KATHY: We can see from the way the market is pricing expectations that the expectation is that the fed funds rate will go up to about 4.5% by early next year, where it's expected to peak. But it also indicates that rates may fall slightly later in 2023. Now, that's different from the story we're being told by most of the people at the Fed. They are talking about keeping rates high for an extended period of time. The current mantra is "hike and hold," to make sure inflation comes down.

But I think most likely what the market is looking at is that rapid rate hikes will lead to a recession and/or some sort of financial market problem that will cause the Fed to ease. And expectations can shift―but that's where we are right now.

MIKE: On the stock market side of things, nobody's happy with what the stock market has been doing recently. But what impact does the bond market have on the stock market?

KATHY: The bond market has a big influence on the stock market, and it's a big reason why stocks have sold off. So when bond yields go up, they tend to change the valuation for other financial asset classes. Short-term Treasuries are seen as the "risk free" rate. Financial assets are typically valued in terms of the risk-free rate plus a premium that investors get to take risk. So for the stock market, that premium usually takes into consideration the outlook for earnings and dividends, you know, over the long run. When the risk-free rate goes up, investors naturally take notice. So other assets, like stocks, need to be more attractively priced to bring in that investment, and that often causes prices to fall.

Another factor is that higher interest rates affect corporate earnings, rather directly. First, there's a strong chance that the Fed's rate hikes will slow the economy and produce a recession, so that's not positive for earnings growth. But second, as interest rates rise, companies that need to refinance their debt, or borrow new debt, will find that they will have to pay a higher interest cost, and that can reduce earnings as well. And earnings are the key driver of stock prices over the long run—so again, that can cause prices to fall.

MIKE: Something I've always wondered about the Fed, and I feel like we're seeing this right now: After every Fed meeting, Fed governors hit the speaking circuit, and they opine about what's going on in the market. But lately it seems to have really ratcheted up. Since the last meeting just about every voting member of the FOMC has given a speech defending what the Fed is trying to do. It seems like they are both sticking to an agreed-upon set of talking points while also giving their own spin on the Fed's plans. Is that part of a coordinated plan to communicate to the markets? And is it effective?

KATHY: I feel pretty confident that it is a coordinated plan, because they're almost all using exactly the same words. I think the reason is there was a feeling after the first one or two rate hikes that the Fed wasn't really getting its message across clearly, because the stock market would rally on the idea that the rate-hiking cycle was almost over after every rate hike. So now we've got this heavy messaging, and it's considered one of the "tools" the Fed employs to try and influence where the market is going.

MIKE: The Fed's action has created a situation where newly issued bonds are now more appealing than the bonds a lot of investors are currently holding. Some investors have been selling their bonds at a discount, which pushes yields up. But who is doing all the selling? It can't be just individual investors. And why are they selling in this environment? 

KATHY: Well, Mike, the bond market's huge. It has a lot of different buyers and sellers, but it does tend to be dominated by institutional investors―so banks, pension funds, insurance companies, and foreign central banks.

Now some of the selling recently is coming from fund managers, or these institutional investors, who are looking to add higher yields to their portfolios. For example, an active manager of a bond fund who has a goal of generating income for investors might choose to sell some bonds with lower coupons that were issued a few years ago and replace them with newly issued bonds with higher coupons. The NAV, or the net asset value, of the fund will fall, but the fund is likely to generate a lot more income to pay out over time. Depending on the circumstances, it might also generate a capital loss that can be used to offset some gains for tax purposes.

Now, in the case of foreign central banks, it's a little different.  They've been selling Treasuries to prevent their currencies from falling. The dollar has risen to an all-time high against many currencies, especially emerging-market currencies. And that tends to push up inflation in those countries. We're effectively exporting inflation to our trading partners. And it's especially a problem if they've borrowed in U.S. dollars and have to repay those loans when their currencies are weak. Consequently, they've been selling dollars, which are usually invested in short-term Treasuries, to intervene in the currency markets.

MIKE: I want to come back to the dollar in just a minute, because obviously there's a lot going on there. But when we're talking about this bond market, if the big players are doing most of the selling, who is buying up all these discounted bonds?

KATHY: Well, Mike, there are buyers in the institutional market as well. We have seen smaller investors move into shorter-term bonds, because of the attractiveness of short-term interest rates. But even in the institutional market there's interest among buyers. So remember, all else being equal, the price move will bring the bond's yield up to where the market is currently for that type of bond. So depending on what the manager is trying to accomplish―potential capital appreciation, maybe a tax management strategy―there are buyers for bonds trading at a discount as well. For every seller there's a buyer. Just like in the stock market―some investors look for value, some for growth―there are different types of investors in the bond market as well.

MIKE: Well, is there a point at which interest rates get so high that older bonds just can't be discounted enough to be attractive―so no buyers show up?

KATHY: Well, it's pretty unusual that a bond has no value. There's almost always a price. It's possible, say in a bankruptcy situation where a company can't pay its bond holders, that they don't get paid, but even then, in, say, the high-yield or junk bond area―there typically are buyers at the right price.  In fact, there are some funds that specialize in what we call distressed debt―that's debt of companies that are in default or at least on the edge of it. And theoretically the bond might not have any value in those cases―but generally there will be some recovery value to it because it may be converted to equity.

But, again, for the vast majority of bonds, the risk of default is very low. Barring a default, if you hold to maturity, you will get your principal back at par and interest payments along the way. You don't have to realize a loss if the value goes down.

MIKE: I want to look beyond the U.S. because the U.K. has had quite a month. Things got so crazy in the bond market that the Bank of England had to step in, and it did so again earlier this week. Can you explain what happened―and what the effect has been on the global bond market?

KATHY: Yeah, it's been a crazy time. It was a combination, I think, of a crisis of confidence and some technical issues in the bond market. Britain's in a tough place as many countries are. It has high inflation due to the spike in energy costs, a weak economy, and large external deficits―that is, it has large budget deficits and trade deficits. That means it needs to bring in capital to finance those. So when the new government came in, it introduced a "mini budget," proposed steep tax cuts and spending increases that would cause the budget deficit and inflation to rise in the eyes of the market.

So when investors saw that and said, well, to attract capital to fund these gaps, the currency needs to fall, but that makes inflation worse, so the Bank of England will have to raise interest rates. And that combination just sent bonds tumbling. It reached a point where pension funds―that hold the very long-term bonds―had to sell some of their assets to make margin calls and, really, the whole market came unglued. The Bank of England did step in to buy some bonds―they say on a temporary basis―to stop the selling. But it has triggered a ripple effect, particularly through the rest of the European markets, because of these concerns.

MIKE: Do you worry about this situation repeating itself in other countries? Could something like what happened in the U.K. happen here?

KATHY: I don't think it's likely to be repeated in most developed countries. Part of the issue is the U.K. pension funding scheme is different than in the U.S. The methods of hedging are different. You know, but that being said, these are the sorts of accidents that happen when you get sharp movements in interest rates. When the "risk free" rate―short-term U.S. Treasury yields―goes up at a fast pace, it inevitably ripples through markets. There's an old saying that, when the Fed tightens, things break. It's usually the most fragile things that break first. So let's say you think back to the 1980s, we had a very strong dollar, and high interest rates, and we had a crisis in foreign debt in Latin America. We ended up with "Brady Bonds," named after Treasury Secretary James Brady. These were designed to restructure that debt so that the countries could repay.

In the 1990s, it was Long Term Capital Management―that was a hedge fund that had leveraged up corporate bonds to the point that it threatened the stability of the market. So the Fed stepped in to broker a workout deal.

In the 2000s, and most recently, it was the mortgage industry which had leveraged mortgage-backed securities. And on and on it goes. In every cycle when interest rates are low, somebody uses too much leverage, and when interest rates change rapidly, it's often hard for the borrower to catch up. And that can trigger a wave of selling.

Not to be an alarmist, but I do worry about where those pockets of leverage are and what the ripple effects will be. Fortunately, the U.S. banking system is well capitalized now as a result of reforms that were made after the financial crisis. And that's a very good thing in this environment.

MIKE: Well, it certainly is amazing how history seems to repeat itself in these situations. I want to pick up on something you mentioned right there at the end―what are the "pockets of leverage" that you are concerned about?

KATHY: I would say that I'm most concerned about private credit growth―lending that takes place outside of the traditional banking sector. So in this particular cycle, a lot of lending has been done by, say, business development companies and private debt and equity shops. Because the banks have more stringent capital requirements these days, we've seen some of the financing move into the private sector.

The problem is that we don't get as much visibility on the pricing that way because they don't have to mark to market and report it publicly. What concerns me is that the exit strategy is typically an IPO or some sort of public offering. With the way the markets are behaving now, that's going to be a difficult exit. So in many cases, these types of lenders are using leverage to boost returns. That's the kind of leverage that concerns me.

But, again, the good news is―that's a problem for the private sector, not for the public sector. It can certainly weigh on markets―but as long as its outside of the banking sector, the impact on the public market should be limited.

MIKE: Kathy, let's shift to the dollar. We talked about this a few minutes ago. But one of the impacts of rising interest rates has been a rapidly strengthening dollar. Late last month, the pound briefly touched a record low. Currencies around the world have been declining against the dollar, from the euro to the Japanese yen to the currencies of emerging-market countries. A strong dollar is, at least in theory, good for U.S. consumers and not so good for U.S. companies. It's good if you want to travel in Europe or buy a box of Belgian chocolates. But it doesn't feel as though here in the U.S. the price of goods on store shelves are any lower. So how do you assess the strong dollar's impacts on consumers here at home?

KATHY: As you mentioned, a strong dollar should be good for U.S. consumers because it lowers the cost of imports. Every dollar buys more goods and services from abroad. Our purchasing power goes up, and that helps hold down inflation as well. But it does depend on companies passing those savings through to consumers. So if demand is still strong at home, there's not much incentive for companies to cut prices. Now we're starting to see it in some areas―for example, retailers are cutting prices because of too much inventory ahead of the holiday season. So it's starting to happen, but there is kind of a long lag effect for when the dollar has a big move like this.

The other issue is that some prices―say, particularly commodity prices, like oil prices―are set in the global market in U.S. dollars. So there isn't much opportunity to pass through those lower costs.

MIKE: What about the impact on U.S. companies―a strong dollar is not good for companies that want to sell their products overseas, of course. How is that affecting your thinking about corporate bonds?

KATHY: That's right―a strong dollar makes it tough on companies that sell to other markets because it makes their products more expensive and less competitive. In the corporate bond market, companies with large exposure to foreign earnings may be less attractive. You might see their prices fall relative to some other bonds of similar type. But it really depends on the company and whether they hedge their currency exposure and just how much they depend on foreign sales. In, say, the investment grade market―those higher-rated bonds―it likely isn't going to affect bond holders as much as shareholders because bondholders get paid before dividend holders do. So, typically, as long as the company has the cash flow to pay off their bondholders, the change in the dollar is not likely to flow through at that level. It typically flows through more to the bottom line into earnings.

MIKE: Let's talk about that impact on companies because many of the largest companies on the U.S. exchanges are multinationals―Coca Cola, Facebook, Apple, Procter & Gamble, even Disney, and on and on. Will the strong dollar have a big impact on their earnings and hence their stock price?

KATHY:  Oh yeah, our colleague Liz Ann Sonders has written about this recently. I think about 40% of the earnings for S&P 500 companies originate overseas. Now some companies will hedge their exposure―and that maybe limits the impact on their earnings. But a strong dollar also means it's harder to be competitive. So it can take a toll on earnings.

MIKE: The other side of the dollar equation is the impact it has on other countries. We're such a global economy now that a slowdown in other countries impacts us. Clearly the strong dollar is hurting other economies, so how worrisome is that?

KATHY: The concern is rising as the dollar continues to hit new highs. Since most goods and many services traded globally are priced in U.S. dollars, it makes the cost of those goods go up outside the U.S. And that is how we export inflation to other countries. But it also tends to slow down growth globally. And that spills back to the U.S., because it slows down our growth because we're exporting less. So this is all the result of the Fed hiking interest rates so fast. And it can worsen the global growth outlook―which is already not great due to the energy price shock and the war in Ukraine.

MIKE: Probably the most serious concern is that the strong dollar is affecting the ability of some countries to service their debt. Emerging-market countries are supposed to repay in the neighborhood of $86 billion in U.S. bonds by the end of 2023―so this problem is not going away anytime soon. If other countries go into default, that only exacerbates the global crisis, right?

KATHY: Yeah, EM countries are particularly vulnerable to the combination of rising interest rates and strong dollar. In fact, both the United Nations and the International Monetary Fund recently have urged the Fed to reconsider how fast and how much it's raising interest rates. You know, servicing the debt is likely to get more difficult for some of these countries at a time when they are already dealing with challenges of rising energy and food costs and, ultimately, social unrest.

MIKE: Well, of course, this makes emerging-market bonds less attractive for investors, and that discourages investment in some of these key markets. It's sort of a circle that feeds on itself. So what are the implications of that?

KATHY: Yeah, it means that emerging-market countries that are vulnerable to this sort of situation are facing challenges, and they really won't be able to invest as much in things that tend to propel economic growth longer term―like infrastructure, education, and even basic services. That not only means slower global growth, but it can also be rising social unrest. It's never good when people feel that food prices in particular are affecting their standard of living in a serious way. So it's generally not a good scenario for anyone.

MIKE: Let's wrap up with the question, I think, that's probably on everybody's minds. In an environment where the stock market seems likely to see continuing volatility for an extended period, what role can bonds play? Is the volatility likely to continue there, too? Where do you see the potential opportunities for fixed-income investors right now?

KATHY: We do think volatility will continue, particularly as the Fed continues to raise rates. But we also think that there are some potential opportunities in fixed income today that really weren't there for a long time when yields were so low. So let's go over the four ways that bonds play a role in an overall balanced portfolio.

The first is capital preservation, so, barring a default, you'll get your principal back at par and usually regular interest payments along the way. So right now, yields on Treasuries with maturities of two years or so are paying around 4%. That can be an attractive option for investors looking to earn a positive return with relative safety.

The second role is income generation. So now that yields are higher, investors can earn a much higher income stream in their portfolios than they have for years, and those yields are higher than you can get in other investments―like dividend-paying stocks. So you can build a portfolio of, say, Treasuries and investment grade corporate or investment grade municipal bonds―and have an income stream of 5% or so―without taking a lot of credit risk. And that can really be a good foundation for, say, a retirement portfolio.

The third role that bonds play in a portfolio is to provide diversification from stocks. Now, this aspect of the bond market hasn't worked well this year because interest rates have jumped so much so fast. And that's caused both bonds and stock prices to fall. But now that yields are higher, the outlook is different. The starting point is much better for bond investors going forward, because they can look forward to those higher coupon payments, and that should produce some positive returns going forward, especially if stocks continue to be under pressure.

And then, the last reason that we hold bonds in a portfolio is just for a planning tool. So, since most bonds pay interest on a regular basis, and there's a set maturity date, they are great for planning for future needs, such as, you know, a purchase of a house or maybe a child's education. It provides a level of certainty about having a set amount of money at a time in the future.

MIKE: Well, Kathy, thanks so much for bringing some of your usual clarity to what's a very complicated situation―one that's probably not going to get sorted out any time soon. Thanks so much for joining me today.

KATHY: Thanks, Mike.

MIKE: That's Kathy Jones, Schwab's chief fixed income strategist. You can follow her on Twitter @kathyjones.

Finally, we are less than four weeks from the midterm elections so here's a quick update on where things stand. We continue to believe that Republicans are strong favorites to capture the majority in the House of Representatives, though the size of that majority may be smaller than was thought just a few months ago. A key data point comes out this morning―the September inflation numbers. Declining CPI may help Democrats tell voters that the economy is turning a corner, while a stubbornly high inflation number will be a key talking point for Republicans in the final weeks of the campaign.

But the most intriguing battle of the midterm elections continues to be the battle for control of the Senate. We've got our eyes on two states in particular that may determine which party has the majority. In Nevada, Democratic Senator Catherine Cortez Masto finds herself in a tough re-election battle against Republican Adam Laxalt, the state's former attorney general. Polling has Laxalt ahead by the narrowest of margins. This is shaping up as the best opportunity for Republicans to take over a Democrat-held seat.

The other state to watch is Georgia, where Democrat incumbent Raphael Warnock is running narrowly ahead of former football star Herschel Walker, the Republican nominee. Republicans probably need to win both Nevada and Georgia to capture the majority.

In every election, there are one or two unexpectedly close races that are somehow below the radar. This year, one of those races might be the battle for the Senate seat in North Carolina. Republican Senator Richard Burr is retiring, so it's an open seat. The Republican nominee is Ted Budd, a member of the House of Representatives looking to move to the upper chamber of Congress. The Democrat is Cheri Beasley, who has been a justice on the North Carolina Supreme Court for a decade. This is a race with no incumbent, and neither nominee is a well-known national figure. There has been little controversy and no headline-making stumbles by either candidate. It might be the sleepiest extremely tight race in the country. Democrats know they have an uphill battle in the red-leaning state―they have not won a Senate seat there since 2008. But it's another one to watch.

No matter what happens next month, it's virtually certain that the margin in the Senate will be no more than a seat or two in either direction. In fact, there's a real possibility we could have another 50-50 tie. But the market will be watching the outcome for two reasons.

One is that the new deadline for a government shutdown is December 16―after the election but before the newly elected Congress will take office in January. That deadline to avoid a government shutdown right before the holidays could be very tricky depending on what happens in the election.

But the other is a little further down the road. Sometime in mid-2023, Congress will have to raise the debt ceiling. And analysts are already worried about how that might play out if there is a narrow split in Congress. The situation has echoes of the 2011 debt ceiling battle, in which Congress repeatedly failed to come to an agreement. That put the country within days of defaulting on its debts, saw U.S. debt downgraded for the first time, and sparked severe market volatility. The bitter partisan divide has hardened since then, and analysts worry that a protracted standoff over the debt limit in 2023 could have even more catastrophic implications for the market and the economy. So that's a story I'll be following closely once we see the outcome of next month's elections.

Well, that's all for this week's episode of WashingtonWise. We'll be back in two weeks with a new episode. Take a moment now to follow the show in your listening app so you won't miss an episode. And if you like what you've heard, leave us a rating or a review—that really helps new listeners discover the show.

For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.