MIKE TOWNSEND: April 2025 was quite a month for investors. For the five-week period that began on March 31 and ended at the close of trading on May 2, the S&P 500® was up exactly 0.95%. But that hardly tells the story.
Look beneath the surface of that essentially flat market, and we find a roller coaster. The S&P 500 dropped by more than 14.2% in a span of just six trading days, then rebounded 17.6% over the next 18 trading days. The driver of much of that market volatility was the president's early April tariff announcements. On April 5, he imposed a 10% universal tariff on all imports from virtually every nation.
He announced a series of escalating tariffs on imports from China, which eventually settled at an unprecedented 145%. And the president imposed the so-called reciprocal tariffs on about 90 countries. Those were in effect for only a few hours on April 9, before the president paused them for 90 days as he seeks a series of trade deals. It's no secret that President Trump watches stock market performance closely as a measure of how his policies are being received.
Yet despite the dramatic moves in the equity markets in April, that did not appear to be the motivating factor in the 90-day pause on those sky-high reciprocal tariffs. Instead, it was the bond market. Bond investors confused by the administration's on-again, off-again tariff announcements sold off sharply. Yields on Treasury bonds typically move in tiny increments, a couple of hundreds of a point at a time. But in early April, yields on 10-year and 30-year Treasuries went up by a half a percentage point in just a few days, the largest move in decades. And foreign investors, who hold enormous amounts of U.S. Treasuries, started questioning whether those bonds were still the perceived safe haven they've been for as long as anyone can remember. President Trump noticed. "I was watching the bond market," he said. "The bond market is very tricky." He added that he saw that bond investors were getting "a little queasy," and that led him to the pause in those reciprocal tariffs. The bond market has settled back down for the most part, but the situation raised a lot of questions for investors, most of whom think of bonds as the steady, reliable, and unexciting part of a portfolio. What if that's not the case anymore? 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. Coming up in just a few minutes, I want to get a better understanding of what's going on in the bond market.
We've talked about bonds quite a bit on the podcast in 2025, which is a little unusual for me, as bonds are not at all in my wheelhouse. But it's because bonds have been so weird this year. And it feels like what's going on in the bond market is a much clearer indicator of how investors are thinking about the economic policy decisions of this administration than the stock market. To help me explore that, I'm looking forward to talking with Collin Martin, director and fixed income strategist with the Schwab Center for Financial Research. Collin will join me in just a few minutes. But first, here are three things I'm watching in Washington right now.
At the top of the list is the House of Representatives and that massive budget reconciliation bill that includes trillions in tax cuts and spending cuts. Last week, several House committees began the process of developing all of the details. What's been done to this point is that both the House and Senate have passed the budget resolution, which is just an outline that sets targets of $4.5 trillion in tax cuts and calls for as much as $2 trillion in spending cuts. Now the process of filling in the line-by-line specifics of each tax provision and each spending cut has begun. And as expected, it's proving to be a real challenge. House Republicans are finding that they have a number of internal issues. One is the state and local tax deduction, known as the SALT deduction, which has been capped at $10,000 since 2017. Republicans who represent high-tax states like California, New York, and New Jersey want to see a significant increase in that cap, but it's not an issue that matters to a lot of Republicans who represent other states. So no agreement has been reached. And there are other areas where consensus among Republicans has proved elusive, including potential cuts to Medicaid and SNAP, the food stamps program, as well as how to handle a host of tax issues, from ending the taxation of tip income and Social Security benefits to how to make interest on auto loans tax deductible only for the purchase of cars made in America. Making the math work is a daunting task, and that's why the idea of raising taxes in some places isn't completely off the table.
House Speaker Mike Johnson is pushing the House to pass the whole bill by the Memorial Day break, but that's looking increasingly difficult. Last week, he said that three key committees would delay consideration of their portions of this big bill until the week of May 12, including the Ways and Means Committee, which is responsible for the tax cut portion of the package; the Energy and Commerce Committee, which is the panel wrestling with how to handle potential cuts to Medicaid; and the Agriculture Committee, which is dealing with an internal dispute about whether to repeal Biden-era green-energy tax incentives. That's a sign that a lot of behind-the-scenes negotiating and arm-twisting is still going on. If those committees can complete their work during the week of May 12, then the whole bill could be put together and voted on by the full House during the week of May 19. It's ambitious, but still plausible at this stage. Of course, even if the House passes the bill, it faces a whole set of different challenges in the Senate, which won't even start working on the legislation until June. Treasury Secretary Scott Bessent said last week that he thought July Fourth was a realistic goal for passing the entire package through Congress and getting it to the president's desk.
The bottom line is that this story is only beginning, but it's the story that will dominate the next two to three months in Washington. Second, last week, the White House unveiled its budget request for fiscal year 2026, which starts on October 1 of this year. The White House proposal is separate from the giant tax and spending bill I was just discussing. Instead, this is the start of the regular annual government funding process, which is supposed to culminate with Congress passing the 12 appropriations bills that fund every government agency and every federal program for the coming fiscal year. The White House request is just that, a request, which Congress, for the most part, traditionally ignores as it develops its own plan. But it does send a message to Capitol Hill about the White House's policy goals. And the message this budget request is sending is a doozy.
The White House is proposing to slash non-defense discretionary spending by $163 billion, a cut of nearly 23%. Non-defense discretionary spending, that's a bit of a mouthful, so let me explain. In the federal budget, there is mandatory spending and discretionary spending. Mandatory spending is required by law, and it includes Social Security, Medicare, Medicaid, veterans benefits, and a few other things, as well as interest payments on the federal debt.
All of that comprises about 74% of the federal budget. The discretionary part of the budget is the other 26%. That's what Congress is doing when it works through the appropriations bills each year, allocating that money. But the president's request has taken defense spending off the table as well. In fact, his request is for a 13% increase in defense spending, as well as a 45% increase to homeland security, to boost efforts to secure the border. So that means that non-defense discretionary spending is everything else: housing, health care, environment, national parks, the weather service, education, all the stuff that the federal government does. All of that totals just 15% of the federal budget. So the nearly 23% cut to that section of the budget that the president is proposing will dramatically slash programs across every facet of the government.
Here's the thing, though: The $163 billion in proposed cuts will not affect the budget deficit at all. That's because the proposed increases to defense and homeland security total more than $156 billion, essentially canceling out the cuts. Now, as I said, the White House request is aspirational, and it's Congress that will have to figure out the budget. But with Republicans in control of both chambers, it's likely the White House will put pressure on them to pass as many of these cuts as possible in their appropriations bills. But here's what's important. Unlike the big tax cut and spending cut bill, the annual budget process and the appropriations bills require a 60-vote supermajority in the Senate. There are only 53 Republican senators, so they will need at least seven Democrats to support each appropriations bill. And there is absolutely no chance that any Democrats will support these kinds of drastic cuts.
What all this sets up is a potential government shutdown this October. I'd say the chances of that are very high. Though, of course, we have more than four months to go before that deadline, and lots can change. But the initial salvo from the White House sure doesn't feel like something designed to attract bipartisan support. Finally, I had an interesting experience last week. I was at the New York Stock Exchange when Schwab CEO Rick Wurster rang the closing bell.
The occasion was the 50th anniversary of what is known on Wall Street as May Day, which many consider the most important day in the history of investing. On May 1, 1975, a rule that the SEC had approved abolishing fixed-rate commissions on stock trading went into effect. For the first time in more than 180 years, commissions could be set by the market competitively. It's a day that is widely considered the turning point in the democratization of investing.
Up until 1975, stock trading was prohibitively expensive for most investors. Commissions were set by the exchanges and approved by the SEC. In the early 1970s, investing really wasn't accessible to anyone except the very wealthy. In fact, in 1970, there were more than 30 million individual investors, but that number had dropped to around 25 million by 1975 as high fees and commissions priced most investors out. But the SEC rule change unleashed opportunities for individual investors. And over the ensuing decades, the cost of investing continued to come down, opening the markets to more and more small investors. Today, more than 160 million Americans are invested. The May Day decision was a critical point in the history of the Charles Schwab Corporation as well. Without it, the company probably wouldn't even exist today.
Our founder, Chuck Schwab, had established the company in 1971, but it was hard for an upstart in the industry to compete with established players when commissions were fixed for everyone. After May Day, Chuck immediately began lowering commissions with the goal of making investing more accessible to ordinary Americans. Fifty years later, Schwab's still going strong, with that goal as one of our guiding principles. Last week on May 1, Schwab launched National Investing Day, an education and empowerment initiative encouraging people to dedicate at least one day in the year to explore how they can get invested and stay invested for a strong financial future.
I was thinking last week about what a monumental decision the SEC made back in the 1970s to reverse a regulation that had been in place for decades. At the time, the decision was fought fiercely by the exchanges and many of the long-established financial institutions, but they came around when they realized how many more investors were out there that had been shut out of the markets. But could such a decision be made in today's polarized Washington? I'm not sure it could. Over the last few years, Gary Gensler, who was SEC chair in the Biden administration, undertook an ambitious project to overhaul the structure of the equity markets, but much of what was proposed eventually collapsed of its own weight. It was too complex, too controversial. And given how today's political pendulum swings back and forth, even if it had succeeded, it likely would have been unwound by the next administration. The new SEC chair, Paul Atkins, believes the capital markets need less regulation, not more. He does believe that the cryptocurrency space needs a better regulatory framework, and Congress has made passing legislation to improve the market structure for crypto a high priority. Who knows, maybe in 50 years we'll look back at 2025 as a critical year in the development of that market. For now, however, just a nod of appreciation to the SEC commissioners 50 years ago, who made a decision that has had profound ramifications on investors and the markets ever since.
On my deeper dive today, I want to take a closer look at what's been going on in the bond market, because as I said earlier, it's been pretty weird. On April 9, the day that President Trump's reciprocal tariffs went into effect, yields on a two-year Treasury bond rose by about 30 basis points, the largest intraday move since 2009. That kind of volatility just isn't usually part of the bond market. Things have calmed a bit since then, but it feels like tariffs are continuing to be a big influence on the bond market, and the tariffs don't appear likely to go away anytime soon. So what's the outlook for bond investors?
To help me sort through some of what's been going on, I'm pleased to welcome back to the podcast Collin Martin, director and fixed income strategist at the Schwab Center for Financial Research. He's been with Schwab for nearly 13 years, and he holds the Chartered Financial Analyst designation. Collin, thanks so much for coming back to WashingtonWise.
COLLIN MARTIN: Hi, Mike. Thank you so much for having me back.
MIKE: Well, Collin, bond investors are pretty nervous these days and have a lot of questions. I'm sure you're getting them when you're talking to clients all over the country. It feels like the time when fixed income was the part of a portfolio that you just didn't have to worry about much on a day-in, day-out basis. That time is in the distant past now. We've seen unusual volatility in the bond market in recent years, and especially in the last few weeks, and it's got a lot to do with what tariffs are doing to bond prices. When the reciprocal tariffs were initially announced at the beginning of April, stocks plunged, and Treasury yields fell sharply, as well, because investors left stocks and went to bonds for a few days, driving up the price of bonds. But then things turned around, and bond prices fell. Even the president said the bond market "got a little queasy," and acknowledged that that was one of the reasons he paused those reciprocal tariffs for 90 days. So Collin, what exactly happened there?
COLLIN: It has been an interesting time in the bond market, Mike, and investors are very nervous about what's going on. I do want to offer one little public service announcement because there is a lot of concern out there, but year-to-date through May 6, the S&P 500 was down almost 3% on a total return basis. But the U.S. Aggregate Index, that's an index that we track, that was up more than 2%. So even though there's been some volatility, bonds have actually done pretty well. But it is that volatility, I think, that caused the skittishness and the nervousness. So I think it's important for all listeners to remember that bond prices can actually move and fluctuate in the secondary market. That catches a lot of investors off guard. You buy a bond, you're expected to be repaid at maturity, but then when you see those price fluctuations, it can be a bit surprising when you check your accounts. And then within that bond relationship, bond prices and yields move in opposite directions. That's a key thing to understand. So if interest rates rise, bond yields rise—that can pull the value of your bond holdings down. But it's important to realize that if prices fluctuate in the secondary market, if you buy a bond at, say, a 4% yield or coupon rate and the price changes, that doesn't mean your interest rate will change as long as you hold to maturity. It just matters how new investors, what sort of yield they're going to receive.
Now, going back to early April, when stocks declined, the idea was that Treasuries should perform well. They should see their prices rise and their yields fall because Treasuries are perceived to be relatively safe. They're one of the most liquid investments out there. When there's periods of volatility or uncertainty, investors tend to go to the Treasury market, and that supply and demand, a lot of demand pushes up their prices, and it pulls down their yields. We saw that happen. That's what the textbooks say should happen. We saw that in the early days, but then that trend reversed a little bit, as you mentioned, Mike, and we started to see yields on long-term Treasuries rise a little bit. And I think that's what President Trump was referring to when he said that the bond market got a little queasy. We saw yields rise even before the reciprocal tariffs were rolled back. So we still saw this uncertainty. We still saw stock market volatility, yet yields rose. I think that caught a lot of investors off guard because it's not what we expected to happen, and it looked like instead of investors seeking shelter in the perceived safety of Treasuries, it looked like investors were actually leaving the asset class, and we were starting to see more sellers than buyers. And this was the concern for President Trump, most likely because he wants lower interest rates. He's pretty vocal about that. That shouldn't be much of a surprise. But he specifically talked about the 10-year Treasury yield, not so much what the Fed does, although he's vocal about that, as well, but he talks about the 10-year Treasury yield. And if interest rates rise, if Treasury yields rise, that makes it more expensive for our government to service that debt. So that could be a reason why he mentioned the rise in yields and how it got a little queasy.
Now, there's no shortage of reasons why yields rose. It could have been because foreign sellers maybe lost a bit of confidence in our government. Maybe they realized they didn't need to hold as many dollars if there is a prolonged trade war, or it could have been the potential inflationary impact from tariffs because if tariffs lead to inflation, inflation rises, usually that would pull Treasury yields higher.
MIKE: So now we're in this waiting period on those tariffs, and we're about a third of the way through that 90-day tariff pause, at least on those reciprocal tariffs. The president has talked about how he wants to make a whole bunch of trade deals, but it seems unlikely that a lot of trade deals will get finalized in that relatively short period of time, so maybe tariffs go back up again. If that's the case, what can bond investors expect?
COLLIN: The honest answer, Mike, is we don't really know. There's so much uncertainty right now, but we do have a few scenarios. If tariffs, as they stand now, or if they were to go up, we think that would be bad for the economy because that would likely raise prices for consumers, and then it can slow consumption at the same time. We've already started to see that sort of cocktail play out in surveys lately. We've seen business and consumer confidence surveys fall. There's a lot of uncertainty out there. So I think businesses are a little bit uncertain about what to expect, and they're unlikely to invest in their business much given that sort of outlook. They might think twice about buying new equipment or maybe signing a new software contract, or if they were considering expanding to a new or second location, maybe they hold off plans there. And then that can spill into the labor market as well, or their employees. They might freeze their hiring plans or maybe they begin to cut staff if their earnings outlook would be a little bit cloudy. And so that's something that we're focusing on. The labor market could weaken where we start to see job losses and a rising unemployment rate.
Now, the flip side, if tariffs were to be rolled back, we think the outlook would improve. Heading into the year, the economy was generally on solid footing, so we could kind of get back to that. So if businesses, whatever their plan was for 2025, if we're kind of back to that baseline, maybe they don't lay off workers, and maybe they go ahead with whatever hiring or expansion plans they had.
So for bond investors in the negative scenario, the high tariff scenario, that would likely mean lower bond yields and more Fed rate cuts than currently expected. In that situation, Treasuries would probably perform pretty well, meaning their prices could rise in the secondary market. That can be good for current bond holders, especially if they choose to sell. But even if they don't choose to sell, you can just see a higher value in your account, kind of give you some peace of mind.
Now, in the scenario where if tariffs were rolled back, we think yields could rise a little bit further from here. That would pull their prices down a little bit because we'd likely get fewer rate cuts than are currently being priced into the market right now.
Now, the direction of interest rates and potential Fed policy, that should always be a factor when investors are considering how to invest in the bond market because if the Fed is expected to cut rates and cut rates sharply, if you're in a short-term investment, like a Treasury bill that's maturing in 12 months or less, you would likely face reinvestment risk there. So when that T-bill matures, you'd probably see a lower yield that you'd be reinvesting in when that came due.
Now, if the economic outlook were to improve, and let's say the Fed isn't cutting rates as much as expected and we see long-term yields rise, it could make sense to be in short-term investments because that will give you more flexibility to take advantage of a potential rise in interest rates.
MIKE: Collin, there's a lot in that answer I want to unpack, and I'm going to come back to the Fed in just a minute, but I want to pick up on something that you said around possibly the loss of trust across the globe by foreign investors. Other countries may still be buying our debt, though there have been reports that China has been reducing its holdings, and even Japan has said that it might reduce its holdings of U.S. Treasuries, but it's really the private sector that's sort of voting with their dollars and choosing not to buy U.S. bonds, right?
COLLIN: It seems like that, but we don't know for sure because we don't really get timely data. So this has been a major headline over the past few weeks, the idea of foreigners selling Treasuries. The fact of the matter is we get that sort of data on a major delay. We get the data from the Treasury, it's called the Treasury International Capital, TIC, the TIC data, but it's released with a six-week delay. So if we want to see what happened in April, we're not going to get that report until mid-June. So we really don't know for sure, but we do think if foreigners were selling, it's more likely to be private investors, like you mentioned. Official investors, so governments or central banks, they've seen their share of Treasuries outstanding decline for years now. Foreign official holdings of Treasuries make up about 30% of the whole Treasury market, but they were about half of all Treasuries about 15 years ago. So their purchases, their ownership, hasn't kept pace with the rising Treasury issuance. And China—that's a big example that people like pointing to—they hold less than $800 billion in Treasuries. Their peak was $1.3 trillion. In percentage terms, according to the official data, China holds less than 3% of all Treasuries, but back in 2011, they held 15%. So their influence is a lot less than it used to be. Now, it's possible that they do hold elsewhere. They could use custodians that are based in either Belgium or Luxembourg. That's a hot topic these days. But the data we see, it looks like they're holding fewer and fewer.
So that goes to the private sector, individual investors, institutions, things like that, their holdings have increased steadily over the years, and we think it's possible that maybe they chose to sell on all this tariff news. Given the somewhat adversarial nature of these policies, maybe investors decided that they might not want to hold as many dollar-denominated assets as they used to, dollar-denominated investments.
And I think a key point is if the goal of this administration is to actually reduce trade deficits, that means that foreigners down the road should actually have fewer U.S. dollars. And as it stands right now, even though we have trade deficits, we have capital account surpluses, meaning foreign investors tend to take that money and just reinvest it back in the U.S. If they have fewer dollars, maybe they don't do that down the road.
MIKE: Well, let's talk about the dollar for just a second because I'm getting this question at every one of my in-person events, I'm sure you are too. So what do you think about the dollar? It's been declining in recent weeks, and probably the question that I get asked the most, is there a risk that the dollar loses its status as the world's reserve currency?
COLLIN: We don't think there's a risk, at least not anytime soon, and mainly because there aren't many alternatives to replace the dollar. If you look at foreign currency reserves, the dollar's share has been declining for years, but it's still really high. It still represents roughly 60% of all global reserves. It was about 67% about 20 years ago. Global trade is generally done in U.S. dollars. That would take a really long time to change.
Now, the short-term outlook, we do think it suggests a modestly weaker dollar, but we don't think it suggests a loss of reserve status. And even when we're talking about this, Mike, the weaker dollar, the dollar has been strong for years. That gets lost in the mix. So even though it's declined over the past few weeks and months, and it's off its recent peak, it's still elevated compared to where we were 10 or 11 years ago.
Now, a weaker dollar can mean a few things for our economy. It can increase the cost of imports, and that could be a bad thing because when considered with tariffs, that could keep inflation elevated, but also could make our exports more attractive. I know that's a key theme for the current administration. So the recent decline in the dollar is probably welcomed by President Trump.
MIKE: Well, Collin, let's shift to the Fed for a minute. The Fed, of course, met earlier this week, chose to leave the fed funds rate where it was. That in itself, not a big surprise. They'd been telegraphing that for weeks now. Fed Chair Jerome Powell has repeatedly said that the Fed is data-driven. Well, last week they received a lot of data, but much of that data is sort of from before the tariffs really kicked in. Not much time has elapsed since those universal 10% tariffs went into effect. And a lot of the data is backwards-looking, so it represents what's happening in March or in the first quarter before any of those larger set of tariffs kicked in. So what is the Fed really paying attention to right now?
COLLIN: I think what they will be paying attention to is the data that we haven't really gotten yet, as you mentioned. What we've gotten since the tariffs have been announced has really been data that came before the tariffs. We've gotten a few things here and there. And we have to differentiate between what we call hard and soft data because they can tell different things depending on the environment. When we talk about soft data, those are survey-based indicators. They can be things like consumer confidence, job prospects, there's surveys that track that, business outlooks that we get from the various regional Fed district banks, inflation expectations, things like that. They can be telling because if consumers or businesses expect something down the road, that can influence their habits in the here and now, but it's not what's actually happening; it's what could happen.
So the hard data is really what the Fed's going to be looking at. They're going to be looking at the unemployment rate, not just job prospects, but what is happening with the actual labor market. Is that unemployment rate rising, falling, or holding steady? What is inflation as measured by any of the number inflation indicators, like the Consumer Price Index or Personal Consumption Expenditures, how has inflation evolved over the past few months? What is our actual economic output doing? Not just what are surveys suggesting, but what does our output look like now?
Now, the soft data, that survey-based data is very, very bad right now. I really can't overstate that enough. Whether it's surveys from the University of Michigan or the Conference Board, we've seen expectations from consumers and businesses fall really, really sharply over the past handful of months. But that doesn't mean the Fed will preemptively make a move because of what might happen, what could happen. They want to see what's actually happening. Because if we go back a few years, Mike, we saw some disappointing soft data in 2022 and 2023 from the sharp increase in interest rates, and there were concerns that a recession could come. It never came. So the Fed doesn't want to act in advance pre-emptively here in case that slowdown doesn't arrive.
What we do think the Fed is going to focus on is the labor market. I think that's a key piece of the puzzle. The good news is that we got some hard data there. We got the April jobs report, which might not be the best indicator because it was just a few weeks after the tariff announcement, and it might not be indicative of how businesses are going to plan over the next few months. But that being said, we did get it for April, and it generally met expectations. You could argue that it actually came in a bit stronger than expected. So that's good news. But the Fed will most likely focus more on the May, the June, the July labor market reports to see how the next few months look.
Now we did get one important release last week, Mike. We got the first quarter Gross Domestic Product Report. That is hard data. Now, it was for the first quarter, so that's pre tariff, and the headline was negative. On an annualized basis, it fell by 0.3% in the first quarter. It was the first negative print since the first quarter of 2022. But that headline doesn't tell the whole story. A lot of the decline was due to net exports. There's a number of components of GDP, but net exports is one of them. And what we saw was leading up to the tariffs a lot of companies started importing more and more on the threat of tariffs. They wanted to import goods before a tariff got slapped on. So more imports than exports led to a pretty negative net export number. That weighed on that headline. If you looked under the surface, it wasn't as bad as that 0.3% annualized loss suggests. Under the surface, it looked like growth was still in the 2.5 to 3% area, which is generally in line with recent quarters.
MIKE: So there's a bit of a disconnect between the hard data and soft data. I appreciate that explanation on the difference there. Of course, as you know, Collin, the Fed has a dual mandate, price stability and maximum employment. The tariffs are likely to result in higher prices and potentially a higher inflation, while also causing companies to consider reducing their workforce or perhaps at least slow or suspend hiring. At a speech he gave last month at the Economic Club of Chicago, Fed Chair Powell admitted that it's a difficult place for a central bank to be, and that the two parts of the Fed's dual mandate may end up in conflict with each other. So if that happens, how does the Fed react? I mean, will they be forced to choose between the two as they consider maintaining or lowering rates? I'm really interested in your insights on this because I think the reality is even Jerome Powell has said he isn't sure how this is all going to play out.
COLLIN: Yeah, it's a really difficult situation. I think the Fed is in a really tough position right now, but because of what you just said, the Fed has a dual mandate. It's maximum employment. That's the labor market. And price stability. It's another way of talking about inflation. And given everything we're seeing with tariffs and with the general uncertainty, those mandates might end up in conflict with each other. So talking about the price stability, the inflation side of the mandate, if tariffs raise the prices of goods, as we expect they will, to some degree, inflation can stay high or even re-accelerate. So just right there in a vacuum, if you're talking about high inflation, that suggests the Fed should hold rates steady, or you could argue that the Fed might need to raise rates. That doesn't appear to be on the table right now, but it supports the case for the Fed to kind of hold where they are right now. But if we look at the maximum employment side of the dual mandate, we're talking about the labor market there. And if the unemployment rate rises because of all the uncertainty we're seeing right now, if we're seeing consumers actually slow their spending because of increased prices and businesses start to make less money, maybe they start to lay off their employees or have them work fewer hours, that's not a good thing. So in a weakening labor market that supports the case for rate cuts. And we think it's possible that both of these things happen at the same time, we think inflation can remain sticky while the labor market is weakening. So as you alluded to, it does put the Fed in a really tough position right now.
Ultimately, we think the Fed will favor the labor market mandate over the inflation mandate if we were to see the unemployment rate rise sharply enough. But that's not a guarantee. Things can change. Just a few weeks ago, Powell gave that speech where he mentioned maybe he'll focus on inflation. That can change. That's just his view. And right now, I think it's OK to say that from a Fed standpoint … because the labor market in the here and now appears to be holding up. But if a few months go by and we start to see a rising unemployment rate, that might change their outlook a little bit.
MIKE: And I think that's why there doesn't appear to be a lot of consensus out there about what will happen with the fed funds rate, say, for the rest of the year. Traders are now pricing anywhere from two to six rate cuts this year. That's a fairly wide dispersion among analysts and traders. So that has to be based on expectations that unemployment is about to go up, right?
COLLIN: That's right. So those really more aggressive rate cut expectations were likely due to a rising unemployment rate, and likely sharp rise in the unemployment rate. But we keep seeing those expectations change. If we go back just to early February, the fed fund's futures market was pricing in just one cut by year-end, but then by the end of April, more than four cuts were being priced in. So it's kind of been all over the place, and it really does depend on the tariff outlook, and then what sort of impact is that going to have on the economy? So as it stands now, this is early May, the fed funds futures market is pricing in just three cuts. But again, that can change. We got sort of a reprieve when we got the April labor market report. That kind of calmed the markets a little bit, and expectations came down. If we were to see that unemployment rate creeping up or moving up steadily, that would likely change.
It's going to depend on how this labor market outlook evolves over the next few months. If the labor market kind of holds steady or only weakens a little bit, then maybe we see one or two cuts. If we start to see a pretty sharp deterioration, then we are probably going to see three or four rate cuts or more being priced in. So it's going to depend on that incoming data.
So our main outlook here is that we don't expect that next cut to come until the second half of the year. So July or later.
MIKE: Well, while the Fed is wrestling with what it's going to do about rates, there's also another reason the Fed has been in the headlines recently, and that is because of the ongoing tensions between Trump and Chairman Powell. The president has been pretty direct about his desire to fire Powell for moving too slowly to bring rates down. Last month, some of those threats seemed to really spook the markets, and it wasn't until Trump said that he had no intention of firing Powell that the market calmed down a bit. So is this just another distraction? I mean, the market reaction to firing Powell would potentially be catastrophic.
COLLIN: The good news is that he said he had no intention of firing Powell. But if he were to go down that path, we think it would be really bad. We think it could lead to higher yields because the market could kind of lose confidence in U.S. Treasuries and just the inner workings of the U.S. government altogether. Central bank independence is really important for economies to enjoy price stability and economic growth over the long run. And that's what's important. If you have a lack of independence and if you have policy being set sort of in concert with fiscal policy with input from the current administration, they might focus more on short-term goals than long-term goals. And I think that's a risk.
Let's consider the economic environment that we were in at the beginning of the year before the tariff announcements. Growth was relatively strong. The GDP was growing above trend. It was expected to slow a little bit, but it was still relatively strong. But inflation was still too high, that's been going on for a few years now. If the Federal Reserve was pressured to cut rates in that environment and inflation was already still too high, that might re-accelerate inflation because lower rates might boost consumer spending, see more demand for goods and services, and that's usually what causes inflation. So if we were to get that influence and you're doing what wouldn't make the most sense over the long run to boost short-term goals, we think that would be a pretty bad outcome.
MIKE: Yeah, you know, as to the potential firing of Powell, I certainly think it's unlikely that the president would actually try that. I do expect the rhetoric around it will continue. I think the president likes kind of rattling the Fed's chain on this. And I think in some ways that the president wants to be able to scapegoat the Fed, to point to the Fed is not doing what it should be doing. And so I think the language and sort of threats will continue, but I do think cooler heads will prevail on the actual idea of firing Powell.
Back to the fed funds rate for a minute. Obviously, not just a number. Really impacts borrowing costs for businesses, which, in turn, can impact whether the business expands, how much hiring it does, it impacts the company's cashflow and working capital. The fed funds rate has reverberations all over the economy. But even if it comes down multiple times this year, there's no guarantee that the rates that most of us ordinary people pay attention to, I'm thinking mortgage rates, for example, or car loans, there's no guarantee that those will come down. The Fed lowered rates last year and mortgage rates really haven't changed that much.
COLLIN: Yeah, the mortgage rate is something that we know a lot of individuals, consumers, investors, pay attention to, but it's not directly related to the fed funds rate. The fed funds rate is a very, very short-term interest rate, and it influences other short-term interest rates. So for investors, it influences things like money market fund yields, or Treasury bill yields, or the rates paid from very short-term certificates of deposit, think 12 months or less. And then they indirectly influence other sort of bond yields, like the five- or 10-year Treasury yield.
A way to think about that, a 10-year Treasury yield is based on expectations of what the fed funds rate will be over the next 10 years, and it often tends to move in anticipation of the actual move itself. So when the Fed cuts rates or raises rates, the 10-year Treasury yield likely fell or rose sometime before that even happened based on those expectations. And that 10-year Treasury yield is important because mortgage rates tend to be loosely based on the 10-year Treasury. It's not a direct one-for-one, but they highly influence the mortgage rates. And as you mentioned, Mike, last year when the fed first cut rates, the average 30-year mortgage rate was around 6.6%. Today, it's near 6.8%, and that's after the Fed has cut interest rates by a full percentage point. So even though they're down one percentage point in the fed funds rate, mortgage rates are actually a little bit higher. So as you mentioned, there's not always a one-to-one move, and even if the Fed does cut rates, doesn't mean mortgage rates will necessarily fall in lockstep.
Our outlook for longer-term Treasuries, like the 10-year Treasury, is a little bit more nuanced. We think it should trade in a range over the next few months until we get more certainty, more clarity on tariffs. We think over time it could fall a little bit more, and that means mortgage rates could fall a little bit with them, but we don't expect them to fall significantly, unfortunately.
Now, if mortgage rates were to fall significantly, think 5% or less, which I think a lot of investors, a lot of potential homeowners are hoping for that, if that were to happen, it would likely be for bad reasons, like a recession, because that would likely be due to significant rate cuts by the Fed, and therefore a significant drop in Treasury yields. So even though mortgage rates would fall in that situation, that would be a pretty tough time for potential homeowners, because if you're worried about your job and the economic outlook, that's a tough time to buy a house.
MIKE: What about, Collin, the opposite reaction, you know, could mortgage rates go up? One of the impacts that I'm thinking about is from the massive U.S. debt that obviously has us all concerned. The new budget that Congress is working on right now potentially is going to add trillions more to that debt. In fact, the debt ceiling discussion itself in the context of that legislation would raise that ceiling by $5 trillion so that there's even more room to increase the debt. And the talk is that investors could start to view the government as being so highly leveraged as a repayment risk that they'll start to demand a risk premium. And maybe the rate on the 10-year Treasury goes up much higher, maybe to 7% or something like that. Does any of that ring true as a possibility?
COLLIN: You know, the idea of the 10-year Treasury rising to 7%, we don't necessarily agree with that. We get asked the question all the time about the impact of our rising debt, and what that means for interest rates and Treasury yields. And for years we've had the same answer, in that we don't see, and we have not found a relationship. So we've looked at it from a number of angles, and we just don't see a relationship between the debt and deficits, and what it means for Treasury yields. It doesn't mean that can't change at some point over time, but in the past, there just really hasn't been much of a relationship. But we're already very high in absolute and relative terms in terms of our national debt. We have a debt-to-GDP ratio of around 120%. It was just 60% in 2007 before the financial crisis. And that's expected to grow.
So the risk is, and I think what you're alluding to, Mike, is that this could drive up yields because we need to find more buyers for our debt. For every, you know, say, trillion dollars in new debt we need to issue, we need to find a trillion more dollars from someone, whether it's an individual, whether it's a government, whether it's an institution, to decide to buy that. And the case for higher yields is that yields might need to increase to sort of entice new buyers. So if you have someone who is an investor who has never really considered Treasuries because yields are too low, and then they can get 6- or 7% on a Treasury, maybe they would say, 'Okay, you know what? This stock allocation, maybe I'll shift over to a Treasury because it's at a yield that's high enough that I think is attractive.' That sounds okay in theory, but like I said, we just haven't found a relationship.
So when we're asked the question about this, when we talk about what's the upside in yields if the debt keeps rising, we just don't have an answer because there's no relationship that said if debt rises by X amount, then 10-year Treasury yields need to rise by Y amount. We do think yields could rise. We don't think they're going to be stuck where they are for the next few months. We expect them to trade in a range. There could be upside, though. We think that upside is closer to 5%, though, and not that 6 or 7% that you just mentioned.
MIKE: What about municipal bonds? Are investors worrying about how states and municipalities will get through these potentially tougher economic times, or are they seeing some opportunities where there's maybe more strength and less risk in munis?
COLLIN: Well, what I can say is we're seeing more opportunities right now, Mike. We think munis are very attractive right now, and it's something that we've been highlighting for a lot of our clients.
Now, are investors worried? To some degree, yes, but not necessarily because of credit quality. And let me walk you through that. We saw a lot of volatility back in April. We actually saw municipal bond prices fall very sharply after the tariffs were announced, and we saw larger price declines than we saw with Treasuries or corporate bonds. But we think most of those sharp price declines were really due to liquidity constraints in the municipal bond market. They tend to be less liquid than corporates and Treasuries, and we've seen a rising share of holdings in mutual funds and ETFs versus just individually owned munis. So when you have products like that where investors can get it in and out more quickly, you tend to see more potential selling when the outlook gets a little murky. So we saw a lot of outflows from mutual funds and ETFs that held munis back in April, and we think that selling pressure pulled down their prices more than otherwise would have happened.
Now, fundamentally, we think munis are still in pretty good shape. Credit quality may have peaked. The economic outlook is a little bit murkier than it's been, and we've probably seen the peak in credit quality in terms of upgrades relative to downgrades as it relates to the municipal bond market. But munis are still very highly rated, and we think they're starting from a pretty strong position. If we look at the investment-grade municipal bond market, most munis are rated in the AAA and AA range, where if you compare that to investment-grade corporates, most investment-grade corporates are signaling BBB, so the low rung of that investment grade credit spectrum. When we're looking at munis today, we would focus on those with AAA and AA ratings. You know, given that somewhat cloudy economic outlook, we don't want to suggest investors take too much risk and go down to that BBB area to earn potentially higher yields. We'd rather accept what we think are high yields now without taking too much risk.
Now, when we look at the muni market, what gets us excited about it is that their yields have moved up relative to their taxable alternatives, like Treasuries or corporate bonds. So we look at something called taxable equivalent yields. It's how a municipal bond stacks up to Treasuries or corporates after taxes are considered. Now, munis are generally exempt from federal taxes, and they're usually exempt from state taxes if you're investing in a municipal bond from your home state. When you compare that to corporate bonds and Treasuries, they're fully taxable at the federal level, so the income earned on those investments will be taxed if they're held in a taxable account. It's not the case with most munis. So when we look at high quality munis compared to corporates, we found that investors in tax brackets as low as 22% can still make sense when tax advantages are taken into account. Even at a tax bracket in the 22% area, munis tend to make it offer an advantage over corporates. I think that's important because for a lot of investors, you tend to think of munis as only for the highest income earners, and that's just really not the case today.
MIKE: Well, Collin, this is great stuff as always, and I want to end here. Given everything we've talked about, what's your overall thinking on the state of the bond market? You've talked about municipal bonds as a potential place for opportunities. Are there other places that fixed income investors can find opportunities right now?
COLLIN: There's three things we're focusing on right now, Mike. The first is what sort of maturities we suggest investors focus on, and we prefer intermediate-term maturities. If you focus too much on short-term investments, that opens the door to reinvestment risk if and when the Fed cuts rates. But if you focus on long-term maturities, they have a lot of interest rate risk. Their prices tend to fluctuate a lot when yields are rising or falling in the secondary market. So if you're focusing too much on long-term investments, and yields rise, you might suffer large price declines relative to a short- or intermediate-term bond. So we prefer intermediate-term maturities.
Second, we prefer high-quality investments. I'll use this term again, a murky economic outlook. That's kind of our base case right now. There's a lot of uncertainty right now, so we don't suggest investors take too much credit risk, meaning bonds with low credit ratings. We generally prefer Treasuries, investment-grade, corporate bonds, and investment-grade municipal bonds today. So high-quality investments and intermediate-term maturities.
And then finally, or third, even though we prefer high-quality investments, investors don't need to avoid riskier investments altogether. So things like high-yield bonds or preferred securities, we think they could be considered in moderation, but just be prepared to ride out the potential ups and downs. To earn the higher yields they offer, you want to have more of a long-term investing horizon and be ready for some market volatility. And even though we're a bit cautious about volatility and potential price declines, that means there could be an attractive entry point down the road. So if we started to see the prices of riskier bonds fall because the economy slows, or because the stock market suffers another setback, then maybe we find high-yield bonds a little bit more attractive. But for now, we just focus on them in moderation, and then there might be better entry points down the road.
MIKE: Well, Collin, thanks so much. This has been a great conversation. Once again, you've made me feel a bit calmer, I guess I would say a bit less queasy about the bond market. Thanks very much for taking the time to talk to me today.
COLLIN: I am always happy to talk about the bond market, so thanks for inviting me.
MIKE: That's Collin Martin, director and fixed income strategist at the Schwab Center for Financial Research. You can find his commentary at schwab.com/learn.
Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks when my colleague Liz Ann Sonders, Schwab's chief investment strategist, will join me to talk about the state of the economy and how the stock market is reacting to the uncertainty. 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 would take a moment to leave us a 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.
