MIKE TOWNSEND: The Federal Reserve is notoriously difficult for investors to make sense of, in spite of market analysts parsing every statement on monetary policy or the economy, and the financial news networks showing split screens of the market reacting in real time to a statement from the chair.
So in today’s episode we’re going to focus on demystifying the Fed.
Welcome to WashingtonWise Investor, an original podcast from Charles Schwab, where we try to cut through the noise and the nonsense in Washington and figure out what investors should really be paying attention to.
I’m your host, Mike Townsend, and this week we’ll feature a great conversation with Kathy Jones, Schwab’s chief fixed income strategist. Kathy and I discuss the latest actions by the Federal Reserve on interest rates and its support of the repo markets—plus she’ll answer some questions that I know are on the minds of investors, including what it means when the yield curve inverts and whether negative interest rates could ever happen here in the United States. That’s coming up in just a few minutes.
Let’s begin with a quick look at the top issues affecting investors right now.
Washington is always a busy place as the holidays approach. With lawmakers eager to get home, it’s often a time when deals get made and issues that have been stuck for months in legislative gridlock suddenly find a way forward.
But this year the shadow of the impeachment inquiry hangs over Capitol Hill. Up until last week most of the process was taking place behind closed doors. Then last week, public hearings began, and that has increased partisan tensions on Capitol Hill.
I continue to think that the impeachment inquiry itself won’t have much impact on the markets. But the market is likely to be more concerned that the impeachment process will take up all the oxygen in Washington and make it impossible to move forward on other issues.
The most striking example of that is the U.S.-Mexico-Canada trade agreement, or USMCA.
There are multiple signs that if Congress voted on the USMCA tomorrow, it would have enough support to pass both the House and the Senate—a move that the market, I think, would see as a very positive development. But there’s growing concern that a vote on the trade deal could get delayed and derailed during the impeachment process. If the vote is pushed off until 2020, there is a risk that Democrats will grow increasingly reluctant to take a vote on one of the president’s signature initiatives during an election year.
There is still optimism that a vote can be taken by the end of the year to approve this important trade agreement, but there’s no question that the impeachment inquiry increases the uncertainty on the issue.
In other trade news, discussions between the United States and China on the so-called “phase one” deal are continuing. Over the past couple of weeks, China said the two sides agreed to drop some of the tariffs, and President Trump asserted that no such deal was made. There was a little bit of market reaction to the statements—positive when the China statement was released, then a turn to the negative when the president responded, though the market quickly rebounded.
As an investor, I’m not overthinking the back-and-forth news. I chalk it up to standard negotiating tactics. China wants to see some or all of the tariffs dropped, so it’s in their interest to put pressure on the U.S. negotiating team on that issue. And on the U.S. side, those tariffs are the chief leverage point—so it makes sense not to concede them too early.
My view is that the two sides will get the phase one deal done in the next few weeks and find a time in December to sign it. I expect that, as part of the deal, the 15% tariffs set to go into effect on about $150 billion in Chinese imports on December 15 will be canceled, and it’s possible that other tariffs already in place will be rolled back. But there is essentially no chance that all the tariffs would be dropped. That would be part of the conversation for the next round of talks, if and when the U.S. and China move toward a “phase two” deal.
Finally, a quick update on the retirement savings legislation that we focused on in Episode 4. We’re talking about the SECURE Act, a bipartisan bill that the House of Representatives approved by a whopping margin of 417-3 back in May. Among other things, the bill would lift the age at which investors must begin taking required minimum distributions from their retirement savings account—raising that age from 70½ to 72.
Now the bill has been stuck in limbo in the Senate for several months, but recently there was another attempt to find an agreement to bring it to the Senate floor. A proposal to debate a limited number of amendments and then vote on the bill itself was put forward by Senate leaders. There was an objection, so the process has not been agreed to yet. But it shows that there is real interest among Senate leaders in getting this bill across the finish line. Negotiations will continue, and there is still some hope that the bill could get finished before the end of the year. It’s likely that the last chance for the bill to pass in 2019 will be to attach it to a larger package of legislative items in December. We’ll keep our eyes on that.
On today’s Deeper Dive, we’re going to take a closer look at recent actions by the Federal Reserve and their implications for investors. I’m really pleased to be joined by Kathy Jones, Schwab’s chief fixed income strategist. Kathy is terrific at explaining what’s going on at the Fed and in the fixed income markets, which can be confusing.
Kathy, thanks for joining me today.
KATHY JONES: It’s great to be here, Mike.
MIKE: Let’s begin with the most recent action from the Federal Reserve at their meeting late last month. For the third straight meeting, the Fed lowered the basic interest rate, but Fed Chair Jerome Powell signaled that they’ll now take a pause and leave rates unchanged for at least a little while. So can you explain the Fed’s decision? What’s changed?
KATHY: Well, as you mentioned, a pause is now likely.
The Fed decided to reduce the fed funds to a low enough level—1.5% to 1.75%—that it should provide extra stimulus to the economy. It’s now below the inflation rate and below the level that Fed economists see as “neutral”—neither stimulating nor slowing the economy.
So the big change is that this move “un-inverted” the yield curve. This new rate is low enough that short-term interest rates are below long-term rates, a sign that monetary policy isn’t restrictive anymore. When the yield curve is inverted, it’s often seen as a signal that Fed policy is too tight.
MIKE: So what is the Fed watching for?
KATHY: Well there are signs that the downturn in the global manufacturing sector isn’t spilling over to the U.S. service sector, and that was a concern prior to this. Job growth is still in a good place in the service sector, and consumer spending is still healthy.
The Fed is hopeful that some of the big, potential negative forces are abating—with signs that there may be a trade deal with China and that the worst-case scenario for Brexit is less likely.
MIKE: Well, Kathy, you mentioned that the yield curve has “un-inverted.” So let me follow up on that. First, give us a quick explanation of the yield curve and talk a bit about why it got so much attention in the media when it inverted earlier this fall.
KATHY: The yield curve is simply a depiction of what yields are for different maturities of bonds, such as three-month yields, one-year yields, five-year yields, etc. We usually talk about the Treasury yield curve.
So an inverted yield curve is simply when short-term interest rates are above longer-term interest rates. For example, when 3-month T-bill rates are higher than 10-year bond yields.
It doesn’t happen often, because usually investors demand higher yields in exchange for tying up their money for longer time periods.
Typically, the yield curve inverts because the Fed is raising short-term rates to cool off the economy and lower inflation. When that happens, the profit margins on bank lending tend to decline and loans are harder to get and more expensive. And that can tip the economy into a recession.
There were a lot of concerns about the inversion of the yield curve earlier in the year because each recession in modern history has been preceded by an inverted yield curve. So many people took it as a signal that a recession is likely in the next 12 months or so.
However, it should be noted that not every inverted yield curve has led to a recession. There have been a few false signals in the past. So I’m not convinced a recession in 2020 is inevitable.
Now, while the four most dangerous words in finance are “It’s different this time,” I think it actually might be.
This time around, the inversion of the yield curve was driven, to a large extent, by falling long-term rates due to a weak global economy.
There’s still plenty of credit available to borrowers and the cost of that credit is low—unlike in past cycles that preceded a recession.
MIKE: Well, that’s great to remember. How worrisome would it be if the yield curve inverted again?
KATHY: It really depends on why it would reinvert. If it inverts again because the Fed raises short-term interest rates, and credit availability tightens up—that is, if businesses and consumers have trouble getting loans—then I would be concerned about a recession coming.
MIKE: Well, Kathy, let’s go back to the Fed’s decision-making process for a moment. Over the course of the Fed’s moves this year, there has not been unanimity at the Fed—there has been real division among the voting members about the course of action. How unusual is that? And what should we make of it?
KATHY: There is often disagreement about policy at the Fed. It’s actually encouraged. The Fed governors want to have a robust debate and reflect various views. The Fed is set up so that each region of the country is represented for the purpose of reflecting different economic circumstances around the country.
Janet Yellen was particularly keen on hearing a wide range of views, and that has carried into Powell’s Fed.
But, at the end of the day, the Fed’s Open Market Committee has to decide on a course of action, and that’s where the vote comes in.
I think it’s a healthy sign that the leadership is open to various points of view, but it can be difficult for the Fed to communicate a single message to the markets when there’s a wide range of views. That can lead to more volatility.
MIKE: One thing you hear discussed on the financial news—and this is definitely something I am getting asked about when I’m speaking at events with investors around the country—is whether the Fed, and central banks in general, are running out of tools to address possible global economic risks. What does it mean to run out of tools—and is it true?
KATHY: Well, if you ask people at the Fed, they’ll tell you that there’s still plenty of ammunition left to counter a potential downturn in the economy. The Fed can still cut interest rates, it can and engage in quantitative easing again—the bond buying program that they put in place after the last recession—if the economy really tumbles into a downturn.
And, as a last resort, the Fed could engage in what’s called “helicopter money”—it’s something described by Milton Friedman years ago, and later by Ben Bernanke, and that’s where the central bank makes large amounts of money available directly to the public in order to drive consumer spending.
However, you know, monetary policy isn’t a cure-all for everything in the economy and that’s what worries some people in the markets.
The Fed can reduce the cost of money and make it more widely available, but it may not be enough to counter the effects of, say, trade wars or fiscal policy issues.
MIKE: Is the ability of the Fed to use these tools impacted at all by the relentless pressure from the White House? The Fed asserts its independence—but the very fact that we’ve been having a conversation nationally for months about whether the Fed can remain independent in the face of criticism from the White House raises questions about whether they have the autonomy to use these tools
KATHY: Well, it certainly can make it more difficult for the Fed to use its communication tools because it has the potential to undermine their credibility.
For example, if politicians are publicly calling out the need for the Fed to lower rates, then if the Fed lowers rates, it looks like it’s caving into pressure—even if they think it’s the right thing to do, and it’s something they would have done otherwise.
The public doesn’t know if the Fed is responding to pressure or not—and that undermines its credibility, which is crucial to making policy effective.
Much of what the Fed does is through signaling—letting markets know what it intends to do and why. And that gets harder if you have a lot of outside interference confusing the message.
The Fed really values its independence from politics—because it provides credibility to their policy making.
MIKE: Well, one of the big stories this fall has been the Fed’s intervention in the so-called repo market, which it has done to relieve pressure on the money markets. Now, this is a complicated story—so can you explain what’s going on in plain English?
KATHY: Well, I’ll give it a shot. The issues in the repo market have to do with what we often refer to as the financial system’s “plumbing.”
“Repo” is short for repurchase agreement. And it’s basically a short-term loan backed by some collateral—usually a Treasury note. These loans are made on a large scale and frequently during the day and keep the financial system liquid.
There are two sides to these deals. On the one side, there are folks holding assets like Treasury notes. These might be banks or hedge funds. On the other side are folks with a lot of cash that want to make some extra money on that cash, like money market funds and asset managers.
When the banks need cash, they’ll borrow from the money market funds on a short-term basis—usually overnight. The banks will pledge the Treasury notes as collateral and repurchase them a day later to pay off the loan. The money market makes a little extra interest on the loan with very little risk.
MIKE: Well, how does this situation affect bonds and bond trading?
KATHY: The recent issue that has come up was that some of the folks with excess reserves pulled back from making those loans, and the rate on those loans spiked up—causing concern that perhaps a financial institution might be in trouble and was hoarding its cash. But that doesn’t seem to be the case.
It looks like it was due to a combination of factors. From a long-term perspective, the Fed has gradually reduced the level of reserves in the banking system as it’s been bringing down its balance sheet, while the banks are required to hold more capital under regulations passed after the financial crisis. As a result, there hasn’t been as much liquidity in the system to keep rates on those overnight loans at or under the fed funds rate. Now when that happens the Fed needs to step in to provide that extra cash.
And that’s what it’s been doing since September. It’s now planning to increase the amount of reserves over a long-term basis as a way to address the issue.
MIKE: So it sounds like you’re not too concerned about all this?
KATHY: In my opinion, this is a problem that the Fed can address, and it doesn’t appear to have broader implications for the financial system.
MIKE: Another issue I know that you and I are both getting asked about when we are out on the road meeting with investors is negative interest rates, which have been happening in countries around the world and have been the subject of more than a few tweets from the White House in recent months. Could negative interest rates happen here?
KATHY: Well, my view is it’s unlikely for several reasons.
First, the Fed has indicated it’s not sure it can adopt negative policy rates under its charter from Congress. This is a bit of a gray area for them.
Secondly, given the structure of the U.S. financial system, I think it would be very difficult. Money market funds are a big factor in our financial system, unlike in some other countries, and so negative policy rates would be very difficult to handle.
Just about every investor in the U.S. has money in the money market. Just imagine if the yields in those investments were negative. That would really create a lot of problems.
Another reason is that the U.S. is not facing a deflation problem—as Japan and Europe were when they moved to negative rates. So bond yields seem unlikely to go negative.
And there’s a growing consensus that negative rates aren’t really working very well—because they hurt the banks and they haven’t produced the kind of growth that was hoped for.
And then lastly, the supply of U.S. Treasury bonds is large and growing because we have a large and growing budget deficit. As we get that extra supply, I think it would make it harder to push yields into negative territory.
MIKE: Well, let’s talk for a minute about that budget deficit. Here in Washington, a number of policy decisions over the last few years have accelerated the growth of the federal deficit, now about a trillion dollars per year. And the federal debt is approaching $25 trillion. What are the implications of the rapidly rising debt load that the country is facing?
KATHY: Well, it’s really a concern. But the fact is that there’s no statistical relationship between the level of our debt and the level of our interest rates. And if you look around the world, you see a similar story—places like Japan where the debt-to-GDP ratio is 300%, and yet interest rates are near zero. So as our debt level has grown, our interest rates have fallen—so it isn’t as simple as it would seem logically.
I think what really matters is debt sustainability. Can a country service its debt?
Now, right now, in the U.S., that isn’t a problem. U.S. Treasuries are in high demand, both domestically and abroad, and that is helping hold down interest rates and making it easier to service the debt. We also have the advantage of having the world’s reserve currency, which feeds into that underlying demand for Treasuries.
However, it would be better from an economic point of view if the growth rate in our debt were lower than the growth rate in the economy—keeping it in the sustainable range. We risk having the cost of servicing the debt taking up a bigger and bigger proportion of the budget—crowding out other areas that need funding and that can potentially slow down growth.
The bottom line is that it’s a concern, but not one that is likely to affect the markets until something changes. How will we know when that happens? I think a key indicator of a change would be a steep drop in the dollar—not just a cyclical decline in the dollar, but one that was driven by foreign investors backing away from U.S. investments. We haven’t seen any signs of that happening.
MIKE: Kathy, we’ve touched on a lot of concerns that fixed income investors have. Yet we all agree that fixed income plays a critical role in a balanced, long-term portfolio. So, let me wrap up with the question that is probably most on the minds of investors—what does all this mean for fixed income investing?
KATHY: Well I think for a fixed income investor the important thing to do is focus on what you can control and less on what you can’t control.
You can’t control Fed policy or how much liquidity there is in the financial system.
But what you can focus on is having a financial plan that’s consistent with your tolerance for risk, understanding what you are investing in, and keeping down costs and taxes.
You can also diversify your fixed income portfolio to gain balance.
So we suggest continuing to invest in bonds—despite the lower yields—as part of your overall asset-allocation strategy.
And we usually suggest keeping the bulk of your holdings in core bonds, such as Treasuries and investment-grade municipal and corporate bonds.
MIKE: Kathy, thanks for helping shed some light on what the Fed is doing and why we should be paying attention. It’s great, as always, to get your insights.
KATHY: Thanks for having me on the show, Mike.
In my Election 2020 segment, there are two events I want to mention that have the potential to reshape the race for the Democratic nomination for president. The first is the possible late entries into the race by billionaire businessman and former New York City Mayor Michael Bloomberg and former Massachusetts Governor Deval Patrick.
Both Bloomberg and Patrick announced months ago that they would not be candidates. And with a field that once had as many as 25 candidates—and today still has 17—it’s hard to make sense of getting into the race at this late date.
But Bloomberg and Patrick have both voiced concerns that a lot of Democrats reportedly have—a fear that the large field has not produced a unifying candidate that can beat President Trump next November.
Both bring unique characteristics to the race. Patrick is a highly respected two-term governor who is also one of the most prominent African-Americans in the party. He believes that he can bridge the liberal and more moderate wings of the party, win the nomination, and then win over moderate voters in the general election.
Bloomberg’s willingness to spend virtually unlimited sums of his own money certainly makes him a possible candidate worth watching. But another billionaire in the race—environmentalist Tom Steyer—has spent north of $50 million already, without moving beyond the low single digits in the polls.
And Bloomberg’s billionaire status plays right into the hands of the progressive wing of the party. Senator Elizabeth Warren of Massachusetts, Senator Bernie Sanders of Vermont, and others in the race see Bloomberg‘s entry as providing a great foil for their proposals to rebalance wealth in the United States by significantly increasing taxes on the wealthiest Americans.
Interestingly, Bloomberg has said he does not plan to compete in the first four states—Iowa, New Hampshire, Nevada, and South Carolina—and instead will focus on Super Tuesday, which will see 14 states voting on March 3.But the path of skipping the early states has been tried before—never successfully. Usually, the winner or winners of those early states have gathered so much momentum that it becomes impossible for a different candidate to emerge later on. But Bloomberg’s ability to spend millions on advertising and organizing across 14 states simultaneously—something that will be difficult for most of the more established candidates in the race—makes this strategy at least worth watching.
We shall see whether the late-entry strategy can work for either Bloomberg or Patrick. If nothing else, it’s a sure indicator of how unsettled and unpredictable the race remains less than three months before the first votes are cast in February.
And the other important thing to watch in the 2020 race is the next debate, which takes place tomorrow night in Atlanta. There are 10 candidates who qualified to be on the stage—which is still a lot, but more manageable than the unwieldy 12-candidate debate that took place last month. As we wind our way towards the February primaries and caucuses, expect these debates to get increasingly animated, as the candidates jockey to differentiate themselves.
For investors, I expect that means more talk about tax proposals in this debate and the next debate in December, as that is becoming an issue where there are real differences among the candidates.
In our Why It Matters section, I look at a story you might have missed and let you know why it’s important. This week, I want to make sure everyone knows that the IRS announced increases to the 2020 retirement savings contribution limits. Next year individuals may contribute up to $19,500 to a 401(k) or other employer-sponsored plan—that’s an increase of $500 over this year. And if you are over 50 years old, the additional “catch up” contribution you can make rises to $6,500—another $500 increase.
Contribution limits for Individual Retirement Accounts remain unchanged for 2020, at $6,000, with an additional $1,000 catch-up contribution if you are over 50 years of age.
Finally, the IRS announced earlier this year that the 2020 contribution limit for a Health Savings Account will increase by $50 for an individual from $3,500 to $3,550, and the limit for a family will increase from $7,000 to $7,100.
Why does it matter? Well, it’s important to know the new limits so you can update your deferrals to take advantage of those increased limits where you can. Maximizing your tax-advantaged savings opportunities is critical to helping you reach your retirement goals.
Well, that’s all for this week—happy Thanksgiving to all my listeners! I’ll be back on December 3 with another episode of WashingtonWise Investor.
Until then, thanks so much for listening. Please consider leaving us a rating and a review on Apple Podcasts or whatever app you use for listening—those ratings and reviews really do matter in helping our show reach a wider audience. Also, make sure you subscribe so you don’t miss an episode. For important disclosures, see the show notes or schwab.com/washingtonwise, where you’ll also find transcripts of every episode.
To keep in touch between episodes, follow me on Twitter: @MikeTownsendCS.
I’m Mike Townsend, and this has been WashingtonWise Investor. See you next time—and keep investing wisely.