MIKE TOWNSEND: I've been analyzing politics for three decades now, and presidential election years are always my Super Bowl season. The last few months before an election are, for me, a dizzying stream of travel to speak at client events and conferences, trying to make sense of the latest polls, watching debates, dissecting candidate policy proposals, looking at fundraising numbers and advertising buys, parsing the snappy soundbites, and more.
As I've been traveling recently, the most common question I've been getting has been something like, "Have you ever seen anything like this?"
And the short answer to that is no. Just think of all that has happened in the just the past three months: The disastrous debate for Joe Biden. The assassination attempt that wounded former President Trump and killed an attendee at one of his rallies. The Republican Convention, when Trump seemed to be widening his lead over Biden. The Biden decision to drop out of the race and the quick coalescing of Democrats around Vice President Harris as the replacement candidate. The Democratic Convention. The first Harris-Trump debate. A second assassination attempt. And that doesn't even begin to capture the day-in, day-out craziness of this campaign.
But here's what's interesting—the markets, for the most part, have been tuning all of it out. Instead, the markets, especially in the last couple of weeks, have been hyper-focused on the Federal Reserve. Would central bankers finally begin the rate-cutting cycle, after 14 months of holding the fed funds rate steady? Did they start too late? Would they cut by more than 25 basis points to make up for lost time?
Finally, we have our answer—the Fed did begin the rate-cutting cycle earlier this week. The market, of course, was not surprised—Fed officials and the data they follow both made it pretty clear that a cut was coming.
But as is always the case, it's not where the Fed starts, it's where it is headed—and why—that matters.
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.
Amidst everything else going on in the political world recently, it's the Fed's decision-making that may have the most impact on the market over the coming months. But what will the Fed be watching for? And what signals is the Fed sending? Coming up, I sit down with my good friend Kathy Jones, chief fixed income strategist here at Charles Schwab, to talk about the Fed decision, what the data is telling us about the economy, and where the Fed is heading.
But first, here are three things I'm watching right now in Washington.
Congress is back in the nation's capital, in the middle of a three-week September stretch of being in session. And there's really only one major issue on the agenda before the end of the month: funding government operations. And lawmakers want to wrap that up quickly, because what they really want to be doing is campaigning in their home districts. The goal is to finish up sometime next week, and then Congress will be off from the end of September until a week or so after the election.
This government funding fight is really no different than the battles we see in Washington every fall. It's all driven by the fact that the government's fiscal year ends on September 30, and Congress is supposed to pass the 12 appropriations bills that fund every federal agency and program by then to ensure that there is no government shutdown when the new fiscal year begins on October 1.
But the bitterly divided Congress has, to date, passed exactly zero of those 12 bills. So the negotiations underway on Capitol Hill right now are about a short-term extension of funding that will keep the government open until after the election, likely until sometime in December. Then Congress will return to Washington after the election for what is known as a lame-duck session and will have to deal with a longer-term solution on the government funding issue then. That post-election session of Congress is usually very contentious and unpredictable. Depending on the election outcome, Congress may just end up passing another short-term extension of funding until the new Congress takes office in January.
For now, there continues to be a bit of uncertainty about exactly how long the temporary extension of funding will last, and what other policy issues, if any, could be attached to it. But the endgame here seems pretty clear. The majority of members of both parties have no interest in shutting down the government five weeks before Election Day. A temporary extension, likely without any extraneous attachments, is virtually certain to pass sometime next week. And then lawmakers will be able to focus full-time on campaigning right through the election.
Second, as we roll out this episode, there are 46 days until the election. So here's my quick assessment of the state of play. Following last week's debate, Vice President Harris seems to have opened up a bit of a lead nationally. But the race remains tied because the seven battleground states remain tied. Arizona, Georgia, Michigan, Nevada, North Carolina, Pennsylvania, and Wisconsin—all seven are polling well within the margin of error. I prefer to use aggregate polling results like those displayed by 538, a website that is a subsidiary of ABC News. They do a great job of compiling all sorts of polls, weighting them by various factors like methodology and sample size and giving us a snapshot into how the race is shaping up.
And right now, it is ridiculously close. As the week began, the average margin in five of the seven battleground states was less than 1%. I expect it will stay there right up until Election Day.
As to the battles for control of Congress, my view from this summer that Republicans are very likely to win the Senate majority has not changed. Republicans need to flip just two seats to gain control of the Senate, and they have all but flipped one already, in West Virginia, where Democrat-turned-Independent Senator Joe Manchin is not running for re-election. Republican Governor Jim Justice is the Senate nominee in West Virginia, and that is an easy win for the Republicans.
The other state I'm watching is Montana, where the Republican nominee is political newcomer, businessman and former Navy SEAL Tim Sheehy. He is leading Democrat Senator Jon Tester in the polls and is a slight favorite to win that seat, which would give the Republicans the majority. There are also competitive races for seats that Democrats currently hold in a half-dozen other states. While Democrats are polling ahead in those states, the races are close. The most likely outcome is Republicans capturing the Senate majority by a couple of seats.
But the House of Representatives remains a toss-up, and I'm seeing signs that give the slightest of advantages to the Democrats to win back control of the House, as Kamala Harris's entry into the presidential race seems to be having a bit of a down-ballot effect as well. There are also more Republicans currently representing districts that voted for Joe Biden in 2020 than there are Democrats representing districts that Donald Trump won in 2020—those are typically the most competitive districts, and Democrats have a few more opportunities to flip those races.
But whatever happens on November 5, I think one thing is certain—the margins in the Senate and the House will be razor-thin, as they've been over the last two years. And that will make it very difficult to solve some of the pressing issues on the agenda next year.
Which brings me to my third update. There's been a lot of talk in recent weeks about taxes from the presidential candidates, a topic that's never too far from the minds of investors. So I wanted to share a couple of thoughts.
As we have noted on this podcast numerous times, there's going to be a massive battle over tax policy in 2025 because all of the 2017 tax cuts are set to expire at the end of next year—including lower individual income tax rates, the higher standard deduction, the higher amount of assets that can be inherited without triggering the estate tax, and many more. Congress will have to decide whether to extend all of those expiring provisions or extend some while letting others expire.
Former President Trump has called for extending all of the expiring cuts. Vice President Harris has said she would extend those impacting individuals earning $400,000 or less, but she would let some affecting wealthier filers expire. Both candidates have also been talking recently about what else they would add to a comprehensive tax package.
Trump has proposed eliminating the tax on tip income, ending the tax on Social Security benefits, and having no federal tax on income earned for overtime hours. Harris has proposed new tax incentives for newborns, for small business owners, and for first-time homebuyers.
But two proposals from the Harris campaign are particularly notable for investors, and I've been receiving a lot of questions about them during my recent client events.
First, earlier this month, Harris proposed a capital gains rate of 28% for individuals with more than $1 million of income. She has also proposed increasing the net investment income tax from 3.8% to 5%—producing a top capital gains rate of 33%. That's higher than the current capital gains rate, but it represents a significant departure from President Biden's proposal, which would have a top capital gains rate of 44.6%.
Second, Harris has said that she supports President Biden's "billionaire's tax," which includes taxing unrealized gains for individuals with more than $100 million in assets. But the taxing of unrealized gains does not have the kind of support, even among Democrats, that it would need to move forward. On the list of tax proposals I'm watching, I'd put this one very low on the list.
So what to make of all these proposals? Do any of them stand a chance of actually happening? Well, it's important to remember that presidents cannot change the tax code. Only Congress can do that. And presidential candidates make a lot of policy proposals on the campaign trail, many of which are never even considered by Congress.
We won't really have any idea about the prospects for tax code changes until after the election, when we see what the balance of power in Washington will be in 2025. There is a process that can be used on Capitol Hill to expedite tax bills, the most important feature of which is that they cannot be filibustered in the Senate. A tax bill needs only a majority of each chamber to pass, and then it can be signed or vetoed by the president. If one party controls all three branches—the White House, the House, and the Senate—then that party can, if it remains unified, pass a tax bill relatively easily.
But a divided Washington is the most likely outcome—and that will make next year's tax debate a difficult one, as the two parties will have to negotiate compromises. All of these proposals being put out right now by the presidential candidates will likely change a lot in that process, if they are considered at all. Whether it's changes to the estate tax or the capital gains tax, it's just too soon to know what might happen. So investors should be wary of making any strategic moves now in anticipation of a very unpredictable tax debate next year.
On my deeper dive today, I want to take a closer look at the Fed's decision this week to cut rates for the first time in 14 months, the data the Fed is considering, and the implications for the bond markets. I'm really pleased to welcome back to the podcast Kathy Jones, chief fixed income strategist here at Charles Schwab. Kathy, it's great to have you back on WashingtonWise. Thanks so much for taking the time to talk to me today.
KATHY JONES: Great to be here with you, Mike.
MIKE: Well, Kathy, the Fed cutting rates for the first time in 14 months has lots of folks cheering, but I've heard you say that the rate cut itself is not what matters. It's why they cut rates and where the Fed thinks the rate is headed that really matters. So I want to break that down a bit. The Fed has been working long and hard to bring inflation down. In last week's report, inflation fell yet again, and we're getting close to the Fed's magic number of 2%, which has long been its target for inflation. Most people would naturally think that with inflation under control, the Fed feels comfortable easing up and cutting rates. But I'm guessing you see more to it than that.
KATHY: Yeah. Well, certainly, that's a big component, but it's really the rising unemployment rate that I think is the key to why the Fed decided it's time to move. Inflation has been falling for quite a while, and it is getting close to the Fed's target, and in fact, on a three- or six-month rate of change basis, it's at 2% or below by most measures.
But it's the weakness that we've seen in the labor market, I think, is the catalyst for the Fed to get moving. The Fed has this dual mandate to keep inflation low and to target full employment. And with the unemployment rate moving up, and job growth starting to slow down, and inflation in the rear-view mirror, I think there's just no reason for policy to be so tight that it weakens the economy enough to cause unemployment to rise more. And we have seen the pace of job growth slow down. Unemployment has moved up from 3.4 to 4.2% since January. In past cycles, we've seen once unemployment starts to rise, it typically can move up pretty fast and can push the economy into recession or be a reflection of the economy being in recession. So I am pretty confident that's what the Fed is now focusing on in setting policy.
MIKE: Yeah, let's dive into those jobs numbers just a little bit more. After the pandemic, job growth really strong, hit a record high of 7 million jobs per month in early 2022. And of course, no one expected that to go on and on, but in recent months, hiring has dropped below where it was before the pandemic. And as you point out, the unemployment rate has been rising for about a year now. But here's where I think people get stuck. The unemployment rate still remains quite low. It's ticked up a little more than a half a percentage point since January, which I don't think strikes the ordinary person as a particularly significant difference. So how is the Fed looking at that job data, and how does that influence their decision on rates?
KATHY: So the increase has been rapid, and it has actually triggered something called the Sahm Rule, that's S-a-h-m, which signals that you're in a recession. So the Sahm Rule was created by Claudia Sahm, a former employee at the Federal Reserve, and it states that when the unemployment rate rises by half of 1% above the three-month average of the low of the last year … so that's a lot of numbers in there, but in those circumstances, she observed that we've always been in recession. Now, even Claudia Sahm, for whom the rule is named, doesn't think we're actually in a recession now. She thinks this is the exception to the rule.
But she also notes that it does mean that the labor market has started to deteriorate fairly quickly. And now I will note that I just interviewed Claudia recently for our podcast that we'll publish this week, so we can get a complete update on her views. But overall, when there has been this slowdown in the pace of job growth, and a rise in the unemployment rate, and a moderation of the price of wage gains, those trends do signal a looser, if not a weaker, labor market. And that's the trend that the Fed wants to counter.
MIKE: You can catch that Claudia Sahm interview on Kathy's podcast that she mentioned with Liz Ann, called On Investing, which we're big supporters of here at WashingtonWise.
Well, Kathy, layoffs get a whole lot of press, and people get talking about the tie between layoffs and recessions, but it's that drop in hiring that's the real indicator of a possible recession. So where do things stand now? What is the outlook for a recession from your perspective?
KATHY: Well, I don't necessarily think that we are in a recession. Obviously, it's very difficult to know as you enter one that this is actually going to unfold in such a way. But recession is a broad-based decline in economic activity, not just one thing or another. We have seen positive GDP growth, etc., so it doesn't indicate we are there. But again, when I come back to looking at the labor market, that slowdown in hiring is often a precursor to mass layoffs, and so that's something to be concerned about.
But really, more importantly, there are a lot of new entrants to the workforce that are struggling to find jobs. Recent graduates from college and high school are finding it takes a lot longer to get into the workforce, and people who are unemployed are taking longer to find another job, and that delays income growth, household formation. It has a big impact downstream in terms of economic growth. There just isn't as much activity in the labor force as you typically see in an economy that's growing at a healthy rate. So it does suggest, at a minimum, a softer pace of economic growth and a potential for recession if the dynamic doesn't improve.
MIKE: Well, as the parent of a recent college graduate who has struggled to find the kind of job she really wants, I certainly understand what you're saying there.
OK, so back to the actual rate cuts, and here I'm assuming that there will be more to follow of course, but earlier you pointed out that once unemployment starts to rise, it moves pretty fast. So if the Fed is cutting rates to stave off a recession, what's your thinking on how quickly they will make additional cuts, and how low the rate might eventually go?
KATHY: Yeah, this is the debate that's been raging for quite some time in terms of we know the direction of travel from the Fed. We don't know the speed or the destination. So if you look at history, typically, if we've been in a growing economy, then the Fed moves at a more moderate pace. So it's always a judgment call. This time around the fed funds rate has been very high relative to inflation. The upper bound of the target range was 5.5%, and inflation is running near 2.5%, and that really left the Fed a lot of room to get started on cutting rates and cutting into that big gap.
But all that being said, the interesting part of this meeting is how the Fed members are looking at the economy and inflation. Again, we know the direction of travel, but where are we ending up? My view is that the terminal rate, and that's the rate where the Fed will likely stop cutting rates, will be somewhere in the 2.5 to 3% region, but some are arguing it may be as high as 4 to 4.5%. So I think that's, personally, relatively high, given that we have an aging population, which typically means slower economic growth and lower inflation. In aggregate, older people tend to spend less than young or middle-aged people, who are still in the household formation stage and buying houses and appliances and new cars, etc. That sort of stage of purchasing is usually behind an older population. It doesn't mean every senior citizen is sitting at home, but as a group they spend less money, and that slows the economy. We've seen this in other countries, such as Japan, which has experienced very slow growth for a long time as its population aged.
MIKE: Well, Kathy, you mentioned this sort of household formation period, and it gets me to wondering who are rate cuts good for? I mean, it seems logical that those wanting to buy a home will be in better shape, but how quickly does a drop in rates translate to lower mortgage rates? And of course, businesses that need to borrow, how much of a cut is necessary to really make a difference to them?
KATHY: Well, it makes a lot of difference for the reason you state. So financing costs for consumers and businesses have been very high, and they're significant, but it does take time to filter through in some cases. So in the past, lenders have been very quick to raise borrowing costs on things like credit cards and car loans, etc., and slow to drop them. They tend to wait until demand for borrowing slows before they start cutting the cost of financing.
We might see a faster response in this cycle on the mortgage rates side since demand has already been soft for new homes. And so there's room to see those rates come down. They've actually come down a bit because long-term rates have come down. But I do think it will take a few cuts to make a big difference in the economy. Just a handful of cuts, 50 basis points or so, doesn't really bring rates down very much for the average business or the average consumer.
MIKE: Well, Kathy, here's a question I'm getting all the time right now. I expect you're getting this, also, when you're out on the road. We're less than two months from the election. While the Fed maintains that it is not a political body, not influenced by politics, this cut came very close to the election, and it's led at least some voters and analysts to question whether the Fed is being influenced by the political landscape. So is it unusual for the Fed to make a move on rates this close to an election? Does the Fed think about this stuff at all?
KATHY: It's not unusual, and it has happened in the past that we've seen rate changes, both hikes and cuts very close to elections. Fed officials are appointed by politicians, and in some ways, the Fed is a political entity, but it's also allowed to be independent. And the Fed really strives to be independent of the influence of politics. I would also argue that the way the Fed is structured, with representation from various districts around the country, mandated term limits, it's hard to argue that there's a majority of Democrats or Republicans at the Fed. You have quite a mix. Moreover, in this circumstance, given the long lags between rate changes and the impact on the economy, if the Fed really wanted to influence the election, it would have probably started making changes months ago. A rate cut six weeks before the election, or two months before the election, probably not going to resonate very much with voters. It's not going to have that much impact on the economy. And also keep in mind for people who believe that somehow Fed Chair Powell wants to see the current administration re-elected, he's a lifelong Republican. He was appointed by President Trump. So I'm not sure that that analysis makes any sense anyway.
It's an issue the Fed considers. It wants to stay away from even the appearance of being political. But all those considerations have to take a backseat to what's happening in the economy. The Fed has been data-dependent all along. They continue to indicate they will be data-dependent, and what's happening recently is that inflation is falling, and the unemployment rate is moving up, and that's why the Fed is changing policy.
MIKE: So this Fed meeting in the rear-view mirror, and now we don't get another meeting until after the election. In fact, the November meeting begins the day after election day. With all the talk that has gone on about how they didn't start raising rates soon enough, and then they didn't start cutting rates soon enough, what will the Fed be watching for between now and this next meeting? And maybe over a longer-term question, how will it know when to stop lowering rates?
KATHY: Those are great questions. So I'm sure the folks at the Fed are going to keep a close eye on inflation and the labor market as usual. Those are the two big factors for them. Since it takes a while for policy changes to have an effect on the economy, it may watch inflation expectations closely to see if those are shifting. The good news is that in this cycle, expectations about inflation remained pretty low even when inflation was spiking up, and that's going to be important to watch. Eventually, the Fed will need to address the fiscal policy in Washington. But as you continue to point out, Mike, we really won't have a handle on what kind of legislation Congress is likely to pass for a very long time. I mean, taxes and tariffs, there are a lot of big unknowns. So the Fed can't really address those in policy until after there's actual legislation in front of them to deal with.
MIKE: Yeah, there's no question that the Fed is kind of like the rest of us in looking at these big issues that are going to come up in 2025 with the next Congress, like taxes and a debt ceiling debate, and know that those are potentially going to have implications for the economy and for some of these things that the Fed is watching closely. And yet there's just nothing that anybody can do or know until circumstances play out through the election, we see what the configuration is in Washington next year, and can start to make some, at least, projections about how some of those issues will proceed.
Well, Kathy, I really appreciate the deep dive on the Fed. I just think it's fascinating to think about how the Fed operates in these kind of not completely cut-and-dried situations. But I really want to talk also about the implications for the bond markets. Savers are sort of the losers here when it comes to rate cuts because they will earn less on their savings. So as Treasury rates fall, where should fixed income investors look for opportunities? We talking corporate bonds, muni bonds? What are you thinking?
KATHY: Well, I think I'll just start with the Treasury market, and that has become a lot more challenging for investors now that yields have fallen so much. A lot of people have been sitting in cash or very short-term bonds because the yields have been high, and they didn't want to invest in intermediate- or longer-term bonds because yields were lower than what they were getting in cash or T-bills, and so there was not a lot of logic or motivation to move. But now as the Fed starts to cut rates, those investors are going to face reinvestment risk as rates fall. That is the yield on that money market fund or T-bills will move lower along with the fed funds rate. So it's going to be difficult to maintain those kind of yields that people have gotten used to.
What we've been suggesting is that investors consider looking at intermediate-term or even long-term securities to hold onto some of these higher yields. Now, our benchmark that we use is the Bloomberg Aggregate Bond Index, and has a current yield right now, as of today, of 4.1%, and a duration of 6.1 years. The Aggregate Bond Index is similar to the S&P 500® for the stock market. It's just kind of a big collection of investment-grade bonds, a combination of Treasuries, mortgage-backed securities, government agency bonds, and as well as some corporate bonds. And so that's the benchmark.
To create a portfolio with those characteristics, we look at opportunities in investment-grade corporate bonds, with maturities maybe in the five- to seven-year range. On the yields right now, the Corporate Bond Index is 4.6 with a 7.2-year duration. So that's a little bit longer duration. More interest rate risk, so a little bit higher yield than the Aggregate Index, which includes things like Treasuries and other government-backed bonds, but you could have some component of investment-grade corporate bonds in there. We also think mortgage-backed securities, which have the implicit backing of the government through the Fannie Mae, Ginny Mae, Freddie Mac, etc., through the agencies. Those offer yields that can be significantly above Treasuries. And we think that's an opportunity there for investors to take a look and maybe add some of those to the portfolio.
Now, for investors in high tax brackets, especially in high tax states, we think municipal bonds can be a good option. On an after-tax basis, those yields can be as high as 6 to 6.5% for somebody in the top tax bracket in one of those states. So given the generally high credit quality in the muni market, we think most investors can consider maturities of 10 years or more to try to capture those yields.
So our overall view is that it makes sense for some portion of your fixed income portfolio to try to capture these yields now before they fall further.
MIKE: Kathy, you've been talking throughout 2024 and even in a year or two before, about the inverted yield curve. Just last week, the yield curve uninverted briefly. What is that telling us?
KATHY: Well, this has been one of those very unusual cycles compared to the past. So inverted yield curves, which just means that short-term rates are higher than long-term rates, have been a reliable inflation indicator in the past, but this time is different. The uninversion now is a return to normal. With the market expecting a series of rate cuts ahead, short-term rates are beginning to fall faster than long-term rates, and the yield curve is starting to revert to a more normal slope. So I think that is a trend that's likely to continue as we go forward.
MIKE: Well, let me wrap up with this. As I've been traveling around the country talking to investors over the last couple of months, lots of anxiety, even as the stock market has performed pretty well year-to-date. And I think the election is part of that. There continue to be geopolitical concerns, and for a lot of investors, things just feel kind of jumpy and unsettled. In recent weeks, we've seen major reactions in the stock market to relatively modest economic news. So in that environment, are investors turning back to bonds as the traditional perceived safe haven? What's your outlook for the bond market for the rest of the year?
KATHY: So Mike, you're right, the bond market is once again acting as a source of diversification during times of stress. During the recent sell-off in the stock market, Treasuries really rallied sharply, and I think that will continue to be the case now that yields are higher. During periods of very low yields, investors just didn't see much value in bonds, and now they're acting like we would expect them to, providing diversification from stocks, income generation, and capital preservation, the three big reasons most people hold fixed income.
As for the outlook, we look for yields to continue lower for the rest of the year, but we do look for that bull steepening in the Treasury yield curve to continue. That is yields likely to fall across the curve, but short-term yields are likely to move down relative to, say, intermediate- and long-term yields. So when I refer to intermediate, I'm usually talking about something in the five- to 10-year area. Long-term yields 10 and beyond. Short-term, maybe out to one to two years. So there's room for those yields to move down, but longer-term yields have already moved down so substantially there's less room for those to move down.
Now, our suggestion for investors is to look beyond the Treasury market when trying to put money to work for more than just a very short-term investment. So yield curves in other markets, like corporate bonds or municipal bonds, are not nearly as challenging as the Treasury market. Yields for intermediate- to long-term bonds are still attractive in our view in those markets, and for investors with a time horizon beyond three to six months or one to two years, we think that that makes sense for a lot of portfolios.
MIKE: Well, Kathy, with the Fed move, it feels like we're on the cusp of a new direction, obviously, and I think it's going to be really, really interesting to watch. Really appreciate your perspective on all this news and developments and just want to thank you so much for being on the show with me today.
KATHY: It was my pleasure, Mike.
MIKE: That's Kathy Jones, chief fixed income strategist at Charles Schwab. You can follow her on X, formerly known as Twitter, @KathyJones. And you should definitely catch the weekly podcast Kathy hosts with our colleague Liz Ann Sonders. It's called On Investing. It comes out on Fridays, and you can catch it wherever you get your podcasts.
Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks, when we will be focusing on the global markets and how geopolitical issues can impact your investing decisions.
Take a moment now to follow the show in your listening app so you get an alert when that episode drops and you don't miss any future episodes. And I'd be so grateful if you'd take a moment to leave us rating or a review—those really help 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.
