NATHAN PETERSON: Hello, and welcome to the Schwab Market Snapshot for June 15. I’m Nathan Peterson, sitting in for Randy Frederick. Today, I’m joined by Kathy Jones, Schwab’s chief fixed income strategist, to discuss the takeaways from this week’s FOMC* meeting. Welcome Kathy.
KATHY JONES: Hi, Nate. Thanks for having me.
NATHAN: So, Kathy, as the market expected, the Fed raised interest rates 25 basis points, but bond yields are going the opposite direction. In fact, the 10-year yield hit its lowest level since November on Wednesday. Why do you think this is happening?
KATHY: Well, it’s really not unusual for bond yields to fall when the Fed is in tightening mode. As they raise rates, the signal to the market is that the Fed is moving to slow down inflation and the economy, and bond yields are very sensitive to inflation expectations. So with the Fed tightening at a time when inflation has already been low and declining, it’s actually a positive signal for bondholders.
NATHAN: So why do you think the Fed is raising if inflation is so low? In fact, their favorite gauge, the PCE Price Index, is at 1½ percent, and it’s actually been coming down over the past couple of months. What do you think the motivation is to continue to tighten their policy?
KATHY: Well, that’s a great question, and it’s one that Janet Yellen was asked at the press conference after the Fed meeting, and she noted a couple of things.
One is that the starting level for the fed funds rate is still abnormally low. It’s actually below the rate of inflation. And so the Fed is very eager to get back to a normal policy stance after this long stretch of very, very low interest rates. So part of the motivation is to just get those rates moving back to something that’s a bit more normal. And that allows them some flexibility if we were to go into a recession somewhere down the road. They would actually have some room to lower rates again.
The second reason, though, is the Fed views the recent decline in inflation as transitory. Meaning there’s just some one-off factors that have pulled it down and it’s going to bounce back up. And that’s based on their models that show when the unemployment rate is as low as it is today, that usually means that wages start to pick up and consumer spending, and that usually sends inflation higher. So in the viewpoint of the Fed, it’s prudent to start—or continuing raising rates right now—even though inflation is low because they see it coming back on the horizon.
NATHAN: One other item the Fed mentioned during their meeting was that they want to reduce their balance sheet. When do you see this happening, and what do you think is going to be the likely impact on the markets?
KATHY: Well, that was a surprise to the market that they actually laid out their plan for shrinking the balance sheet at this meeting. We thought it might happen later in the year, maybe in the fall, and then maybe they would implement it at the end of the year or next year. But, actually, by announcing it at this week—this week’s meeting—it sets the stage for possibly beginning to shrink the balance sheet or move in that direction as early as this fall.
We actually don’t see a huge impact on the market going forward. The Fed’s plan, which has been very clearly spelled-out, is to take a very, very gradual approach to reducing the balance sheet, and letting some of the bonds mature over time, many years over time, so that the impact is limited. So, all in all, we don’t see it having a real big impact on the bond market.
NATHAN: Great. Well, thanks so much for your insights, as always, Kathy. If you want to read more from Kathy you can do so in the Investing Insights section on Schwab.com or you can follow her on Twitter @KathyJones. We’ll be back next week. Until next time, invest wisely. Own your tomorrow.
*Federal Open Market Committee