RANDY FREDERICK: The first FOMC meeting of 2017 is scheduled for this week. Kathy Jones, Schwab’s chief fixed-income strategist, joins me for the January 30 Schwab Market Snapshot to discuss what the Fed’s plans may be and how it may affect bond investors. Welcome back, Kathy.
KATHY JONES: Thanks for having me, Randy.
RANDY: So, Kathy, almost no one is expecting a rate hike, but there’s a lot of talk about the Fed reducing the size of its balance sheet. And, of course, that could bring back some painful memories of the 2013 taper tantrum, which had a huge interest rate spike. Could we see that kind of bond market volatility again this time?
KATHY: It is a risk because whenever the Fed reduces the size of its balance sheet it’s essentially taking money out of the financial system and that’s a form of tightening policy. Now, having said that, I think the Fed is trying to lay the groundwork so the market is not as shocked as it was in 2013. And so what they’re trying to indicate, I think, is that it will be a gradual process. My guess is what they will do is slow down the pace at which they’re reinvesting the principal and interest from the bonds that they hold into new bonds, and just very, very gradually take the size of the balance sheet down to mitigate some of the impact.
The other thing is interest rates have moved up quite significantly over the last year, about 1% or so for the 10-year treasury. So the market isn’t as quite as vulnerable—I don’t think—as it was in 2013. But, nonetheless, this is a form of tightening and I think investors do need to be prepared for the possibility of long-term interest rates going up.
RANDY: Well, now, according to the Futures markets, there’s really not a whole lot of high probability of an interest rate hike until at least June. What, exactly, is the Fed looking at and when do you think the Fed might move on rates?
KATHY: Well, the Fed always keeps an eye on employment and wages, and, right now, the unemployment rate is quite low—it’s below 5%. And wages have been starting to rise—they’re not growing at a really fast rate—but they are picking up, and that’s an indication that we could get some inflation down the road. So that, clearly, is something the Fed is going to keep an eye on and would tend to justify some further rate hikes. But, you know, having said that, there’s a lot of other stuff coming out right now that would influence Fed policy—much of it coming out of Washington. So we have a new administration, with a whole raft of potential policy changes on the agenda. Some of them would be stimulative, like tax cuts and perhaps infrastructure spending, and that could boost growth and inflation. On the other hand, trade policy may involve tariffs, and those tariffs could slow down the economy over time. So I think the Fed not only watching the traditional metrics, but they also have to keep an eye on what’s coming out of the Administration right now in terms of policy.
RANDY: Well, now, you just talked about trade policy, and, of course, that’s not part of the Fed’s dual mandate, but it does seem to be a really big issue for the Trump Administration. How could that issue affect the dollar and the bond markets and what should investors do about that?
KATHY: Well, the trade policy is a big question mark right now. So, on the one hand, if you impose tariffs, that tends to drive up inflation over the short run because import prices go up. But over the long run, that can slow down growth, especially in the manufacturing sector where we’re exporting a lot of the goods that we produce. So it can have a mixed effect on inflation, and that’s something the Fed has to take into account when they set policy.
The other thing is a border tax policy that’s being discussed in Washington—has a potential to push the dollar up rather significantly. And if that were to happen, that tends to act like a rate hike because it sends prices down and slows growth. So I think the Fed has to weigh these various things when setting policy and they’re probably going to wait for more clarity on the details. Nonetheless, we do think that the Fed is likely to raise rates two, perhaps three times in 2017. So for investors, you might want to keep an eye on those long-term bonds, maybe move to shorter-term bonds, so that you mitigate some of the impact of rising rates. And you may want to prepare for a stronger dollar in your portfolio by maybe limiting the amount of international bonds you’re exposed to.
RANDY: Thank you for that great advice, Kathy. Unfortunately, that’s all the time that we have for today. You can read more from Kathy in the Insights and the Fixed Income section of Schwab.com, and you can follow Kathy on Twitter @KathyJones. And, of course, you can always follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.