Economy Is Thriving but Fed Not Ready to Let Go

MIKE TOWNSEND: It's been a busy start to the month of February in the nation's capital with a lot of news for investors to process. In just the first few days of the month, we had the first face-to-face meeting between President Biden and House Speaker Kevin McCarthy, where they talked about the debt ceiling, the slow-moving train wreck that could wreak havoc on the markets later this year if it's not resolved. Last week, the Fed surprised absolutely no one by announcing a quarter point hike in interest rates, the eighth consecutive rate increase, but the smallest increase since last March. Yet the messages sent by Fed Chair Jerome Powell in his news conference were confusing to the markets. What did surprise just about everyone was the January Jobs Report, which highlighted that even in the midst of a series of high-profile layoff announcements in the tech sector, the economy added more than half a million jobs, blowing expectations out of the water, and causing more confusion for investors trying to figure out exactly what is going on with this economy. And, of course, Washington was riveted by the discovery that a Chinese spy balloon spent several days meandering across the United States until being shot down by the military over the Atlantic Ocean. I must confess, I did not have that one on my February bingo card.

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 today's episode, I want to examine how the bond market is reacting to all of this economic news, including the Fed's latest action, the robust Jobs Report, and the looming debt ceiling drama, and find where the opportunities may lie for investors. To help me with that, Kathy Jones, Schwab's chief fixed income strategist, is going to join the show in just a few minutes. But, first, a quick look at what's making news here in Washington.

The initial frenzy of media attention around the United States hitting the debt ceiling last month has died down a bit, as Washington settles in for what is expected to be a months-long saga. Last week's White House meeting between President Biden and House Speaker Kevin McCarthy did not produce much in the way of substance, but then no one really expected it would. Biden reiterated his position that Democrats would not negotiate on the debt limit but said that he welcomes a separate discussion with congressional leaders about how to reduce the deficit and control the national debt, while continuing to grow the economy, a comment that was seen as something of an olive branch to the speaker. For his part, McCarthy told the president that Republicans would only support a debt ceiling increase that is paired with unspecified spending cuts.

After the meeting, McCarthy said the meeting was positive and cordial. No agreements, no promises, except, "We will continue this conversation," he said. And in the end, perhaps the only significant takeaway was the fact that the meeting happened at all, roughly five months before the likely deadline to avoid a catastrophic default, and that plans were made to keep talking. Despite the lines being drawn in the sand, both leaders know that they can't let the country default, and last week was a tentative first step toward ensuring that that won't happen.

One of the side effects of the focus on the debt ceiling over the last few weeks has been a lot of discussion about ways that a financial crisis could be averted if Congress does not act in time. There's been talk of whether the president could unilaterally raise the debt limit, whether Treasury could prioritize debt payments, or whether the Treasury secretary could order the minting of a trillion-dollar coin that could be deposited at the Federal Reserve and used to pay down debts. But these ideas have been routinely dismissed as unrealistic by administration officials. Until Congress signals a clear path forward, however, we can expect these alternative ideas to keep coming up.

Perhaps the most noteworthy comment on the debt ceiling last week came from Fed Chairman Jerome Powell. He was asked at his post-Fed meeting news conference whether the Fed was exploring options to stave off default if the Congress failed to act, and he did not mince words in his reply. "There is only one way forward here, and that's for Congress to raise the debt ceiling," he said. "No one should assume that the Fed can protect the economy from the consequences of failing to act in a timely manner." I think that comment was really designed to send a message to Capitol Hill that some of these outside-the-box ideas that are kicking around are non-starters.

Elsewhere on Capitol Hill, congressional committees have finally gotten themselves organized and started their work. Most of the nuts-and-bolts work of Congress is done through these committees, as they hold hearings, debate legislation, and eventually decide which bills move forward to votes by the full House or the full Senate. The two committees that matter most to investors are the House Financial Services Committee and the Senate Banking Committee because they have direct jurisdiction over the markets.

Last week, the House Financial Services Committee held its organizational meeting during which the new chairman, Congressman Patrick McHenry, a Republican from North Carolina, laid out his priorities for the year. At the top of that list are two issues that are also on the minds of many investors, cryptocurrency and environmental, social, and governance focused investing, or ESG.

Let's start with cryptocurrency. McHenry said that the committee will focus on providing clear rules of the road that protect consumers, while allowing innovation to thrive. The goal is to produce a bill that would create a better regulatory framework for cryptocurrency. Over at the Senate Banking Committee, cryptocurrency is also a top priority. That committee will hold a hearing on February 14 titled "Why Financial Systems Safeguards Are Needed for Digital Assets" that looks at the November collapse of cryptocurrency exchange FTX and its impact on investors. As I've said before, there is genuine bipartisan interest in passing a cryptocurrency bill in 2023. There are other committees that would need to be involved, and there are many competing ideas floating around Capitol Hill about the best way to regulate cryptocurrency, which means there's still a lot of work to be done to produce consensus legislation. But in a divided Congress, this remains one of the few issues where the two parties seem to be on common ground.

The ESG issue, on the other hand, is decidedly not bipartisan, and the debate over environmental, social, and governance focused investing is increasingly acrimonious. The big debate centers on whether asset managers, companies, and regulators should consider ESG factors when making business and investing decisions. Republicans see ESG investing as a way to push what they call a radical agenda. Democrats see ESG factors as part of a prudent assessment of future risks and an opportunity for investors to express their feelings about issues through their investments. Last week, those lines were further hardened when Chairman McHenry announced that he had set up a Republican task force made up of nine members of the Financial Services Committee to "combat the threat to our capital markets by those pushing environmental, social, and governance proposals." That alone gives a good sense of just how politically charged this issue is in Washington. Investors can expect a lot of back and forth between the two parties on ESG issues during this Congress.

One example is the debate over a rule finalized by the Labor Department last fall that allows retirement plan sponsors to consider ESG factors when deciding what investment options to offer to participants in a 401(k)-type retirement plan. That rule effectively overturned a rule finalized during the Trump Administration that did the opposite—it banned plan sponsors from considering ESG factors at all. Now that the Biden Administration has reversed that rule, Republican lawmakers are planning to launch a congressional review of the rule to try to overturn it again. It's a perfect example of the whipsaw nature of the ESG debate, where the issues go back and forth depending on which party is in charge.

Another example is the SEC's proposal from March of last year to require public companies to disclose to investors more information about how they are contributing to climate change and the future risks that climate change poses to their companies. That rule was expected to be finalized last fall, but last week there were news reports that the SEC is considering scaling back the plan in the face of intense pushback from companies and from a group of Republican attorneys general who are poised to challenge the rule in court.

For investors I don't think there's an end in sight to this ESG debate, but I do think we can expect the two opposing views to be highlighted frequently in the coming year by the House Financial Services Committee, where Republicans have the majority, and the Senate Banking Committee, where Democrats have the advantage.

On my Deeper Dive today, I want to look at how investors are processing some of last week's big economic news, including the Fed's first monetary policy decision of 2023 and the surprising Jobs Report, and where the opportunities might be for investors, particularly bond investors. For that conversation, I'm pleased to welcome back to the podcast Kathy Jones, Schwab's chief fixed income strategist. Thanks for joining me today, Kathy.

KATHY JONES: Oh, thanks for having me, Mike. Great to be here.

MIKE: Well, Kathy, let's begin with the Fed. Last week, as we all know, the Fed hiked rates for the eighth straight time. And while this one was smaller, just a quarter point, in his comments, Chairman Powell said, "The job is not done," and he made it clear that the Fed plans to keep rates at a higher level for an extended period of time. However, the market appeared to think that the Fed is bluffing and will begin lowering rates sooner rather than later. Do you think that's the case? And what's behind this disconnect between the market and the Fed? Is the market just hearing what it wants to hear?

KATHY: I think the disconnect stems really from poor communication. My opinion is Powell sort of muddled the message. So the statement that's written and released after the Fed meeting was very clear and direct, as you mentioned. But then he seemed to waiver on the message during his press conference afterwards. I always put a lot more weight on the statement, since it's carefully vetted by the committee to reflect its views. Every word is considered because the Fed knows that the markets will react to it. In this meeting, it was particularly significant, since the market hasn't been pricing in as many rate hikes as the Fed has been signaling, and I think that's because growth has slowed, and inflation has started to come down. So the market was already doubtful about whether the Fed would still hike the fed funds rate to that 5 to 5¼ region, as it had indicated before, and then actually hold it there until the end of the year.

So in the press conference, Powell put a lot of emphasis on how much inflation has fallen to date since the Fed started tightening. He used the word "disinflation" 10 or 11 times. So bond investors jumped on that and took it as a sign that the Fed, or at least Powell, was seeing things the same way that they were—that is, that there's going to be some room to lower rates later in the year as inflation falls.

Now, this kind of push and pull is not unusual, but the gap between the Fed's outlook and what the market has been pricing in has been wide for the past six months or so. It's narrowed a little bit recently, but I think that some of the gap is due to traders trying to get ahead of the next change in the cycle, but also due to relatively poor communication from the Fed.

MIKE: Well, that's really good perspective on the Fed inner workings. Of course, a couple days after the Fed meeting, we received the other big economic news of the week, the latest Jobs Report, and it was a shocker. So what jumped out at you, and do think the Fed saw signs of what it's looking for in the Jobs Report?

KATHY: Well, it really was a big surprise, probably to the Fed, as well as to the market. So the number of jobs increased by over 500,000 in January. Now, it's a huge gain compared to what was expected. But I should emphasize there's some quirks in the data that can explain a lot of that. So this is a release that included annual benchmark revisions, where they go back and they look over the years and revise the data based on updated information. There were adjustments to the size of the population, and that changed some of the underlying figures. There are seasonal factors that needed adjustment, as well. And then they revised the categories that made the numbers look more substantial than I think they might have otherwise. Nonetheless, it does signal that the job market is healthy and that people are finding work pretty easily.

Now, for the Fed, I think the key component of this report is that wage growth is still pretty strong. It slowed down from the pandemic highs, but it hasn't cooled off enough to signal that it's time to ease up on policy. Right now, wage growth is running at roughly 4%, depending on how you measure it. For the Fed, a growth rate closer to 3% or under would probably be a signal to shift policy, and we're just not there yet.

MIKE: Well, I think this issue of trying to slow wage growth can be really confusing because, to the average person, low unemployment and high wages seems like it should be a good thing. The wage growth rate pre-pandemic was typically a little above 2%, and as the Fed pointed out last week, wage growth has been slowing for the past few months, but it still remains well above 4%. So now we're in this environment where there are a lot of job openings, but we have the lowest unemployment rate in more than 50 years, so it stands to reason that businesses have to pay higher wages to attract workers. So I guess I'm wondering what is it going to take to get that wage growth back below 3%.

KATHY: Well, that's a question the Fed and a lot of economists are asking themselves right now, because it has traditionally been believed that higher wages lead to inflation. So they've been trying to squeeze things down so that those wages come back into line with something more consistent with low inflation and a growing economy. But let me point out a few things about the whole philosophy around that.

This recovery has been unique, in that people in lower-wage jobs often bore the brunt of the impact of the pandemic. Those frontline workers were the most affected by COVID. So attracting those people back into those jobs is proving difficult, and many chose to leave the workforce altogether. Others moved on to different jobs. That's not usually the pattern in recessions or downturns. So the labor shortages are most acute in this area, and that's driven much of the increase in wages.

We also lost a few years of immigration, and that we historically have added workers in the areas that have seen, again, these steep pay increases recently, like hotel workers, and restaurants, and agriculture. We learned from the recent employment report that there has been some resumption of immigration back into the workforce, and that should help ease up some of those shortages.

And last, you know, look, there have been times of low unemployment in the past without steep increases in wage rates or inflation as recently as late 1990s and frequently in the early 1960s. Also, I think it's not a bad thing that people in lower-wage professions are seeing their wages catch up to everyone else. You know, their wages have lagged behind in this group for many years, while productivity growth has actually been improving, and corporate profit growth has been very strong for a long time. So it's certainly possible that wage growth can improve without it passing through to overall inflation.

Finally, it's worth pointing out that that link between unemployment rate and inflation just isn't as strong as the traditional models indicate. In fact, it really hasn't been strong for quite some time.

I would say, in general, I think the labor force is still straightening itself out from the pandemic and that the supply-demand balance for labor is coming back into balance, and it will continue to over the course of the year.

MIKE: Kathy, all this is a lot for investors to try to process, and as we do that there continues to be this speculation about whether we are in, or have been in, or will soon be in a recession. Last week, Chair Powell said he still saw a path to a so-called soft landing in which we avoid recession. But at this point, it feels like even if we technically enter a recession, it's likely to be pretty shallow and pretty short. So what is the level of risk that we could head into a deeper, longer recession?

KATHY: Well, I don't think it's a high risk, but the risk really stems from the chance that the Fed will tighten policy so much that it curtails financing that's needed by consumers and businesses to keep the economy going. So that could slow the economy to a crawl or even send it into recession.

Now, we usually refer to this as tightening financial conditions, meaning it gets so costly or difficult for businesses and consumers to borrow for investment or for consumption that it produces a recession. Now, I would say there's already been something of a recession, say, in the housing industry, especially in the market for single family homes, because mortgage rates have gone up so much. But so far, financial conditions haven't really tightened that much.

It hasn't happened yet, but there's always a risk that when you get a rapid tightening in monetary policy, it does occur, and that could trigger us into a recession or perhaps a deeper downturn than we were anticipating.

MIKE: Well, let's step back for a broader look at the bond market. One of your messages heading into 2023 has been that bonds are back. So how are you suggesting investors take advantage of that?

KATHY: Well, what we mean by "Bonds are back" is that 2023 looks like a better year than 2022 by a long shot. 2022 was a very difficult year for a bond investor, to say the least. But they're back to serving the traditional role in a portfolio that we associate with fixed income. And that's after years of near zero or even negative yields. Bonds, once again, are a source of income, capital preservation, and diversification from stocks. It really all comes down to the yield. You can now build a portfolio of bonds without taking an excessive amount of risk and get some yield. You don't have to stretch into riskier parts of the market to get that income.

So we've suggested investors that have been on the sidelines in cash or have a very low weighting to fixed income because yields were low for so long start to increase their holdings of intermediate-term, high-quality bonds. Now, by "intermediate-term," we're typically referring to bonds with maturities of five to seven years or even as high as 10 years. And by "high- quality," we mean the bonds with the lowest risk of default. Treasuries, other government-backed bonds, investment-grade corporate bonds, and investment-grade municipal bonds fall into this category. And, you know, really, currently, you can build a portfolio with yields in the 5% region for several years. We think that's an attractive proposition for many investors as part of their core holdings.

With higher yields and high credit quality, you know, these are the types of bonds that can once again provide that ballast in a portfolio, especially when stocks are volatile.

MIKE: So does that mean that the 60-40 portfolio is back as well?

KATHY: Yeah, I think it is back—not that 60-40 is right for everyone, it never was, but it's not a bad place for a lot of investors to start. You know, over the past few years, a lot of investors were disappointed in the performance of the 60-40 portfolio, mostly because of the 40% allocated to fixed income. In 2022, it didn't provide diversification from stocks, and so performance was poorer in both stocks and bonds. But now that yields are higher and prices are lower, I think that makes sense—to take a look at it again. You know, over the long run, 60-40 has proved to be a pretty good rule of thumb for investors, especially those approaching or in retirement, where capital preservation and income is so important.

MIKE: Well, another topic I wanted to touch on, in his press conference last week, Chair Powell noted that state and local governments are flush with cash. Does that mean there are opportunities in municipal bonds?

KATHY: Yeah, we have liked the outlook for the muni bond market for quite some time, especially from a credit quality perspective. As Powell mentioned, state and local governments, you know, they still have some pandemic funds on hand. Their tax revenues are rising, along with employment, which produces income taxes, retail sales produces sales taxes, and property taxes, which are paid in arrears, so as property prices go up, the state or local government will get increased property taxes into their revenues. And there have, also, in the muni market, been a lot more upgrades than downgrades over the past couple of years, and we think that trend will continue.

The only fly in the ointment is that munis have had a very big rally since the start of the year. So yields have fallen a bit more than in other parts of the bond market. There tends to be a seasonal effect in January. People often move into munis after the end-of-the-year tax-loss harvesting. And while at the same time, early in the year, municipalities don't tend to issue much in the way of new bonds. So the demand tends to be higher than the supply. But, in general, we think from a long-term perspective, munis are a solid place for investors in higher tax brackets.

MIKE: Well, Kathy, as you know, I'm a Washington guy, this is the WashingtonWise podcast, so I can't resist the opportunity to ask you about a Washington issue, and that's the one that everyone is talking about here, the debt ceiling, and the potential for a U.S. default this summer. So are you seeing anything significant in the bond market that reflects those concerns? What are the implications of a lengthy debt ceiling fight, and even a possible default, on the bond market?

KATHY: Well, Mike, so far, the market is taking it in stride. As you mentioned many times, Congress always seems to get a deal done, even if it's at the last minute. And I think that's a going assumption among, you know, most bond investors.

Nonetheless, it's sort of lingering in the background. You know, the Treasury is already having to take these extraordinary measures to avoid a default, and the clock is ticking. But a real crisis is probably at the end of the next couple of months, perhaps in the summer.

About the only impact so far that we're seeing in the market is that the yields for T-bills that mature in that summer timeframe when it could be crunch time—June, July, August—have started to rise a little bit relative to the rest of the T-bill market. And that just means that investors are sort of avoiding T-bills that mature in that timeframe because they don't want to be stuck in something where the payment might get deferred or even a technical default. They're just saying, "OK, if I'm going to have something that matures in that timeframe, I demand a higher yield for it." But so far, it's minimal. It's not as high as it might have been, say, back in 2011 when we really ran into a crunch. But the point is that, you know, Treasury bills usually are used for short-term liquidity, and if you're worried about getting the money when you need it, you'll back away and you'll buy different maturities, or at least demand a higher yield for the risk that something goes awry.

Now, as for a lengthy battle or even a default, it can weaken confidence in the U.S., it could cause foreign investors to demand a higher yield to invest in U.S. government debt, and that could weaken the dollar and make bond yields go up.

But overall, we're all just kind of holding our collective breath, hoping Congress gets a deal done without too much drama.

MIKE: Well, it's hard to separate Congress and drama these days, so I don't know if we'll get that wish.

Well, I wanted to ask one other question, and that's about the dollar. It's fallen quite a bit lately. Is that a start of a new trend? If so, what does it mean for investors?

KATHY: Well, the dollar has dropped about 7% or so from the high it hit late last year, and that's against a sort of a broad range of currencies. But that was a 10-year high, and the dollar spiked up last year largely driven by the fact that the Fed was raising rates much more rapidly than other central banks were increasing their rates. So our interest rates were more attractive, and that pulled in foreign investors looking for better returns. Also, you know, the relative strength of the economy coming out of the pandemic, the higher interest rates, it made the dollar attractive by comparison to, say, the euro, or the British pound, or the Japanese yen, for example.

Now, some of those central banks have started to hike rates, as well, and that has meant that the dollar has given up some of those gains. And we think that trend can continue for a little while. We think the dollar will tend to stabilize near current levels for the next couple of months. But after a decade of rising, a stable or weaker dollar does open up the potential for bonds denominated in other currencies to actually look more attractive for U.S. investors.

We tend to like international diversification as a general principle, but just hasn't made a lot of sense in the bond market until recently. So in 2023, we think it may make sense to start diversifying some of those bond holdings into international bonds.

MIKE: Well, Kathy, as always, we've covered a wide range of topics, and you provided great perspective on all of them, so I really appreciate you making the time to talk to me today.

KATHY: Oh, thanks for having me, Mike.

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

Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. 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.