Transcript of the podcast:
MIKE TOWNSEND: Everywhere investors turn these days, it seems like they run into bad news. Last week's inflation report surprised a lot of economists and analysts by showing that inflation remains persistently high and has not yet begun to abate. We officially entered a bear market on Monday, with the S&P 500® down more than 20% since its record high at the beginning of the year. And more and more economists seem to think it is all but inevitable that the U.S. will enter a recession if we're not already in one. All of this is increasing the pressure on the Fed, which met this week to raise interest rates again. But what will it take to bring inflation under control and restore confidence to the markets?
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. Today, I want to take a closer look at last week's inflation report, what it means for the Federal Reserve's monetary policy decisions going forward, and what it may signal for the bond and stock markets in the months ahead. In just a few minutes, Kathy Jones, Schwab's chief fixed income strategist, will join me to give her perspective on what it might take to get inflation under control and how investors should be interpreting what's going on in the economy and the markets.
But, first, a few quick updates on some of the key issues here in Washington, starting with one that we've been following regularly on the podcast: retirement savings legislation. Earlier this week, the Senate Health, Education, Labor, and Pensions Committee, better known as the HELP Committee, met to approve a retirement bill, the first major action in the Senate on this issue. The House, of course, has already completed its work, having passed the SECURE Act 2.0 by an overwhelming 414 to 5 vote at the end of March. That bill would slowly raise the required minimum distribution age to 75, increase catch-up contributions for individuals approaching retirement age, and take a number of steps to try to make it easier for employers to offer a retirement plan and employees to participate in that plan.
Now, it's the Senate's turn. The HELP Committee's bill includes just some of the provisions in the House passed bill, mostly provisions focused on helping employers set up plans and making it easier for workers to participate. For example, like the House bill, it would reduce the time for a long-term part-time worker to become eligible for his or her company's plan. The bigger part of the bill, dealing with things like contribution limits and the required minimum distribution rules, is in the jurisdiction of the Senate Finance Committee. So once the HELP Committee finishes its bill, that will be merged with the larger Finance Committee bill. We are hearing the Finance Committee could consider its part of this legislation in late June or early July. All of this is just keeping the legislative train on the tracks. This bill has a very good chance of passing Congress before the end of the year, but probably not until after the midterm elections.
There was also some news last week on another issue we've been keeping an eye on, cryptocurrency. A new bipartisan bill was introduced in the Senate that would hand over a lot of the regulatory oversight responsibility for cryptocurrency to the Commodity Futures Trading Commission, or CFTC. The bill would also require stablecoin issuers to have capital reserves as backing, resolve some of the tax uncertainties surrounding crypto, and commission a major study of the environmental impact of crypto mining. While this is just one approach, and there are alternative approaches in the works, including proposals that would give the SEC a much bigger role, it's a significant moment in the process, because it shows just how seriously Congress is starting to take crypto issues. This is going to be a complex and slow process, and I don't think anything will pass this year. But 2023 could be a big year for Congress to try to get a major cryptocurrency bill passed, one that would clarify exactly who in the government has primary responsibility for overseeing the growing cryptocurrency world.
Finally, I want to mention a new issue that I anticipate covering closely in the months ahead, because it has the potential to affect every individual investor. Last week, SEC Chair Gary Gensler delivered a speech in which he outlined his plans to overhaul some of the basic ways in which our stock market works. He called for sweeping changes to how trades from retail investors are routed to the stock exchanges, how they're executed, and how it would be determined whether the trade is getting the best price possible. He also floated ideas like pricing stocks in increments of less than a penny and cracking down on payments made by wholesalers to brokers who send them retail trade orders. All of this is the product of an SEC review of what happened during last year's meme stock craze.
Now, it's really important to understand that what happened last week was just the head of a regulatory agency giving a speech about what he thinks the SEC should do to improve the way our markets work. What the SEC did not do last week is release a formal set of rule proposals on these issues. So there are no details about how any of these ideas would actually work, and, of course, the details matter. While Gensler said he had directed SEC staff to draft these proposals, it's likely to be several weeks before the commission votes to put them out for public consideration. Once that happens, there will be plenty of time for investors of all types to analyze the proposals and participate in the public comment process. As I've said time and time again on this podcast, the regulatory process in Washington is designed to be very, very slow. But there is no question that there are potentially significant implications here for all investors. So this is one regulatory process everyone should be keeping an eye on.
On my Deeper Dive today, I want to dig into the current economic situation, whether the Fed's response is having the desired effect, and where inflation and the markets might be headed in the second half of 2022. To provide some perspective on these questions, I'm pleased to welcome back to the podcast Kathy Jones, Schwab's chief fixed income strategist. Kathy, thanks so much for joining me today.
KATHY JONES: Thanks, Mike. It's great to be here.
MIKE: Well, Kathy, the economic situation we are in now is the product of an extraordinary confluence of circumstances. The pandemic hit, resulting in an unprecedented shutdown of the economy, and the government responded with a huge amount of stimulus. People saved a lot of money. They quit their jobs, they relocated, and then as the economy reopened, they were ready to spend a lot of money, making huge demands on supplies and services at a time when the supply chain was still really unstable. More demand, not enough goods, a broken supply chain, all of it combined to produce the highest levels of inflation in decades.
So let's begin with the latest inflation report, which was released on June 10. It showed inflation remaining persistently high at a level that seemed to catch just about everybody off guard. So what surprised you about the report?
KATHY: The biggest surprise was that core inflation stayed higher, and by core, we mean inflation excluding food and energy, because those tend to be very volatile on a short-term basis. We've been looking for inflation to start to come down a bit as inventories pick up at retailers, etc., but rents and airfares, along with some apparel prices, have been moving higher than we expected. It seems at odds with what we've been hearing from consumers and businesses, but that's what the report showed.
MIKE: Well, Kathy, these might be unfair questions, but do you think inflation has finally peaked? Where do you think it will settle in?
KATHY: Very unfair questions. I'd need to be much better at predicting what will happen in the energy sector and the Ukraine war to be confident in my answer. But I will say, I think we're getting close to a peak, if 'not there already. There's an old saying that the cure for high prices is high prices, and I think that applies here. In other words, if prices move up too much, people consume less because they can't afford whatever goods or services that are increasing in price. And we're seeing some of that in the data on gasoline sales. Volumes are down as people cut back on driving and can't afford to fill the tank all the way. Wholesale prices for a range of goods are falling, as well, from copper to lumber to wheat. As the Fed tightens policy and the economy slows, inflation should recede, but inflation is a lagging indicator of the economy. It may not fall until we've actually entered a recession.
MIKE: Well, Kathy, let's turn to the Federal Reserve, which is front and center in the effort to combat inflation. They met earlier this week and increased the Fed Funds Rate by 75 basis points, the first time there has been a rate hike of that size since 1994. So does the fact that the Fed seemingly made kind of a last-minute decision to increase by 75 basis points instead of 50 indicate that they're worried that their plan isn't working?
KATHY: Well, I think it reflects the concern that inflation is not coming down as fast as they would like it to. And they seem very much in a hurry to get it to come down to reassure markets and people throughout the country that they want inflation to come down, that that's their primary goal. So stepping up the pace is really meant to send a signal, "Let's get this done. You know, let's get to a point where we can be more confident that inflation is coming down."
MIKE: Well, the idea here is to cool the economy, which normally would mean companies paring their hiring and even laying off workers, but unemployment remains high. So what are you watching for as this drama unfolds?
KATHY: Well, you know, unemployment is actually a lagging indicator for the economy and inflation, but it is an important component of watching to see that the economy has slowed down. There are some signs the labor market is cooling off. The pace of growth in new job creation has moderated in the last few months. We were running about 600,000 per month early on in the previous six months. Then it was 400,000 a month. And last month, it was 390,000 new jobs created. Still very strong, but it is the smallest increase in over a year on a monthly basis. It shows that there's some moderation in the pace.
Also, wage growth is still running higher than the Fed would like to see. It's running about a 5% annual pace. Now, it's stabilized, though, in the past few months, and we're seeing more people come into the workforce to fill open positions. So it looks like those higher wages are pulling more people back into the job market. That increases the supply of workers and that can slow down the pace of increase in wages.
You know, at some point, if the Fed continues with its rate hikes, it's inevitable that job growth will slow, and the unemployment rate will rise. Higher interest rates are already starting to hurt the housing market. We've seen some layoffs at mortgage lending companies, since fewer people are buying or refinancing their houses. And we're hearing about layoffs and/or hiring freezes in the tech sector. As demand slows due to Fed rate hikes, hiring will likely slow, the unemployment rate will probably edge back up over 4%, and consumer spending then slows down because people have fewer jobs. Then as they spend less, businesses start to slow their expansion plans, they invest less, and that just has a ripple effect on the job market. For example, if a company lays off warehouse workers because business is slow, then those workers aren't as likely to go out and eat, take a vacation, etc. That means less demand for restaurant and hotel workers. It seems to happen in this pattern in every cycle.
MIKE: So, Kathy, I want to make sure I understand this, because it often feels like the Fed raising rates should translate into something really obvious happening, but it doesn't often feel like it has a direct connection to daily life. Obviously, if you're looking to get a mortgage or buy a car or renovate your house, you do probably notice it right away. But the Fed raising interest rates on Wednesday doesn't mean that my local gas station owner is climbing up his big sign to lower prices on Thursday. So how do higher rates work to bring down inflation, and how long does it take before we see that?
KATHY: Yeah, you're right, Mike. There's no direct link between a given price and the economy and the Fed tightening policy. You know, they used to say, popularly, that the policy works with a long and variable lag. I think it was Greenspan who said that. And the idea being that this is a process; it's not a one-day effect. But as the Fed raises rates, things cool off, the economy slows, then you start to see less in the way of price increases. And that will work its way through, but with a lag. It takes a while. It can take months or even a year to see that inflation come down, particularly when it's been driven, as it has recently, by things that the Fed really can't control, like energy prices, the war in Ukraine sending up food prices. There's very little that can be done directly by the Fed, other than to just slow the economy down.
MIKE: Well, the Fed has long had a target rate for inflation of 2%. Obviously, we seem a long way away from that now. So do you think that's a realistic goal in the near term, or if not, what is a realistic goal?
KATHY: Well, I think in the near term, meaning, say, this year or even over the next year, it won't be easy. You would need to see a pretty substantial drop in, say, energy and food prices, and that does seem unlikely, given the war in Ukraine, and a pretty sharp slowdown in consumer spending, as well, which isn't happening very quickly. But longer term, when we look a few years out, it's certainly not out of the question. If the Fed is willing to tighten policy enough to lower demand to the level of the available supply in the economy, then inflation should come down.
One thing we do watch is what we call nominal GDP growth. That's the growth rate in the economy before you take inflation into consideration. That's been running pretty high as the economy recovered from the pandemic. It looks likely to slow down quite a bit, and that should mean less inflation pressure. You know, another indicator is money supply, and that's just the amount of money that's circulating in the economy. Things like the money in your pocket, in your checking account, your money market fund, cash, things that are available for you to spend right away. And that has fallen pretty substantially. It's not as popular an indicator these days as it used to be. But since we haven't had inflation this high since the '80s, when it was popular, I looked at it the other day. You know, it surged when the economy was coming out of the pandemic, but it's since completely reversed that and fallen back. It was up 26% year-over-year, and now it's back to 8% year-over-year. Excessive money supply growth is usually a requirement for higher inflation, but it's not sufficient in and of itself to generate inflation. But seeing that come back down is reassuring in the long run.
This burst of inflation was really due to a combination of that very loose monetary policy and very aggressive fiscal policy that contributed to the strong burst of demand that we saw coming out of the pandemic. And now, by loose monetary policy, I mean the Fed's decision to cut short-term interest rates to zero and buy up a whole range of bonds to keep interest rates low. At the same time, we had that fiscal stimulus, those stimulus checks and other support payments that went out to help people through the pandemic. A lot of that money was saved initially, and then as we reopened, people went out and spent money again. But there really wasn't enough supply to meet that sudden increase in demand. And so people started paying up for the experiences maybe that they missed, like travel, or going to a wedding, or other things that have been postponed.
Now, we're getting a little bit better supply-and-demand balance. Some of those things are reversing. That fiscal spending ended a while ago. The budget deficit is down sharply. And it's a similar story with monetary policy. Now, the Fed is reversing hiking rates, shrinking its bond holdings, and that means there's just a lot less money sloshing around in the economy―that should translate to less inflation down the road.
MIKE: Well, Kathy, one of the things a lot of economists and analysts are watching is this question of whether the Fed can navigate to a so-called soft landing, which would be to cool inflation without tipping the economy into recession. The Fed's track record in doing so―not that great. So at this point, do you think the Fed even has a chance at pulling off a soft landing?
KATHY: I'm sorry to say it seems unlikely, or that the chances are low. Even Fed Chair Powell sounds doubtful. He talked about a possible soft-ish landing at his press conference in May. Given the amount of tightening the Fed is preparing to do with rate hikes, quantitative tightening, or in other words, reducing the amount of bonds that they're holding on their balance sheet, combined with the tightening in monetary policy in most other major countries, a soft-landing sounds more like an aspiration than a realistic assumption.
MIKE: Well, let's switch gears and talk about the bond market. Earlier this year, there was a lot of talk about the fact that stocks and bonds were moving in unison, mostly in a downward direction, which is not typically the case. What is the bond market telling us about investor sentiment?
KATHY: Well, I think investors are still very nervous and scared about the Fed's shift in policy. You know, it came very, very suddenly. And sort of a pivot was made in December when the Fed decided to signal that it was raising rates, and it's become more pronounced and aggressive as they've talked since then. So I think investors are pretty nervous. They realize that interest rates are going up and they're not really sure how far the Fed will have to go in lifting those rates to cool off inflation. But longer term, this is part of a process. When the Fed raises rates, it will send a signal, typically, to the longer-term bonds that the economy is expected to cool off and inflation will come down. And so that, typically, once we get those expectations built into the pricing and the market, you start to see yields stabilize.
A second factor that's probably working in favor of the bond market down the road is that yields have risen in real terms—that's adjusted for inflation expectations. You know, they were negative for several years, and now they're positive, and that makes bonds more attractive relative to some other options. So we're starting to see some inflows into bonds, especially from institutional investors like pension funds and insurance companies. They're starting to find these yields above 3% in Treasuries as an attractive way to lock in some longer-term income that they need to meet their liabilities. And more recently, certainly in short-term bonds, we've started to see some safe haven buying. So with risk assets selling off, like the stock market, investors often buy risk-free assets like U.S. Treasuries, which are considered risk-free because they're backed by the full faith and credit of the government to keep their money safe and liquid.
MIKE: Well, of course, with the drop in the stock market in 2022 thus far, investors are probably starting to take notice of that 3% yield.
Well, not only is the Fed raising interest rates, it's also started unwinding its balance sheet. For years, the Fed purchased a lot of bonds as part of its effort to keep interest rates low. Now, they're letting those bonds mature, and they're not reinvesting all of that money. So how far does the Fed plan to go with this process, and what impact does that have on the broader bond market for the rest of this year?
KATHY: The Fed's plan, as they've laid it out so far, calls for a pretty rapid unwinding of its balance sheet holdings, at least compared to the last round of quantitative tightening in 2017 to 2019. Now, the goal appears to be to reduce the balance sheet from a high level of 36% of GDP to something in the region of 20 to 25% of GDP over the next few years. Now, when we do the math, that's actually the equivalent of about another 1% increase in the fed funds rate, or 100 basis points. So it's just getting underway, but it is a factor that should slow the pace of economic growth, because they're removing some of that easy money that's been in the economy.
Also, the Fed has been holding both Treasuries and mortgage-backed securities. The mortgage-backed securities have been helping keep mortgage rates low. Now, the Fed is intent on getting those holdings down more quickly than its Treasury holdings. And eventually, maybe even moving back to a Treasury-only portfolio. As a result, mortgage rates have really jumped quite a bit more than Treasury yields, and that is starting to put a crimp in the affordability of new houses.
MIKE: Well, Kathy, corporate bonds feel like they kind of fell out of favor over the last six to 12 months, but they're starting to attract more interest from investors. So what's your take on corporate bonds right now?
KATHY: Well, we think investment-grade corporate bonds—that is, the higher rated bonds with intermediate-term durations, which we put in the five- to seven-year area—can make a lot of sense for investors looking for income. In general, highly rated companies have strong balance sheets and enough cash flow to pay interest on their debt. And many of these companies locked in lower borrowing costs over the last few years, so they're not probably subject to some of the stress that you would get when interest rates rise, refinancing their debt. So with yields in the 3½ to 4% region for a buy-and-hold investor looking for income, we think the risk-reward looks pretty good.
Where we are more cautious, though, is in the lower-rated bonds, high-yield bonds, or junk bonds. Those companies that issue those bonds, by definition, have less in the way of resources to ride out a downturn in the economy, and that's why they tend to have very high correlation with the stock market. The yields are quite high, but the risk is high, as well, especially if we are entering a recession. In some cases, the companies might default on their debt, and that leaves the bond holder with little or nothing in recovery value. I can think of a handful of companies that are in highly speculative areas, like crypto, that might end up defaulting on their debt. So that's where we get more cautious as we go into lower and lower credit ratings on those bonds.
MIKE: Well, you mentioned that lower-rated bonds have a high correlation with the stock market. I know you focus mostly on the fixed income markets, but you do keep your eyes on equities, as well. Is the bond market giving us any clues about what to expect from the stock market?
KATHY: Well, I think the major signal that's coming from the bond market is seen in the flattening or inverting of the yield curve. And what that means is that when short-term yields start to move higher than long-term yields, it's usually a negative signal for the economy and for the stock market. It reflects the fact that the Fed is hiking rates, and that's generally not great for the economy and not great for risk assets, and especially when valuations have been high, as they have been recently.
Right now, parts of the yield curve are already inverted. Five-year yields are higher than 10- and 30-year yields. The yield spreads that the market tends to pay the most attention to are the differences between the yield on a three-month T-bill and a 10-year bond, or between a two-year Treasury note and a 10-year Treasury bond. And the reason is that these are often seen as a pretty reliable signal of an oncoming recession. They aren't inverted yet but seem to be well on the way.
MIKE: Well, Kathy, this has been a great discussion. Last question. As we enter the second half of the year, what is your outlook, and what strategies do you think investors should consider? With the stock market continuing to struggle, a lot of investors are looking to decrease the risk in their portfolio. So do bonds present a good opportunity over the rest of 2022?
KATHY: Well, we think the second half of the year should look much better for bond holders than the first half, which was admittedly pretty bad. But we think a lot of the bad news seems to be discounted by the bond market, which means that if there is an easing in inflation or a slow down in growth, bond yields should start to stabilize and maybe fall from current levels. And when yields fall, that means bond prices rise. But, also, I think investors need to remember that the way bonds work. So even if the price of the bond you hold now falls, you'll still get the interest payments, and the bonds will still mature at par, unless there's a default. So we think the opportunities are coming our way in the second half of the year. It's been a rough first half. We think things look better for the second half.
MIKE: Well, that's great advice, Kathy. Thanks, again, for taking the time to join me today.
KATHY: My pleasure, Mike.
MIKE: Well, that's Kathy Jones, Schwab's chief fixed income strategist. You can follow her on Twitter @KathyJones. Kathy also just published her midyear outlook article, which is definitely worth a read. You can find that on schwab.com/learn.
Well, that's all for this week's episode of WashingtonWise. We'll be taking a little break, so our next episode will drop in July. Take a moment now to follow the show in your listening app, so you'll know when we return, and so you won't miss any future episodes. 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.
After you listen
After the recent disappointing inflation report, the Federal Reserve raised interest rates by 75 basis points—the largest Fed increase in 28 years. Kathy Jones, Schwab's chief fixed income strategist, joins Mike Townsend to discuss the implications for the economy and the markets of the Fed's aggressive move. They also consider whether corporate bonds are a good option in this environment and how the bond market is acting as a signal that a recession may be with us soon.
Mike also provides updates on two bills―one dealing with retirement savings and the other focused on cryptocurrency regulation―that have begun moving through the Senate. And he highlights the potential implications for individual investors of a recent speech by the SEC chair about his plans for a major overhaul to how the stock market operates.
WashingtonWise is an original podcast for investors from Charles Schwab.
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