The Fed's Message: Patience and No Change in Interest Rate Policy

LIZ ANN SONDERS: I'm Liz Ann Sonders. 

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

So Kathy, no surprise this past week that our focus has been on the Fed, and we do a lot more than just watch what the Fed does with monetary policy, its impact on the economy, but it's always top of mind when we're in the kind of inflation backdrop we're in and when we have a meeting of the FOMC like this week. Now, I was speaking at a client event and missed the announcement, which was nothing, the statement, and the entire press conference. So I'm getting information secondhand, but now I'm going to get a firsthand from you since you were writing the Fed commentary, and you were living it as it happened. So no surprise that they didn't cut rates, but what was your reaction to what was sort of bantered about during the press conference?

KATHY: The message from the Fed was patience. If I had to sum it up in one word, it's patience. So no change in interest rate policy. The statement did reflect some caution about inflation getting sticky in the past few months. So there was some wording changes there that acknowledged that inflation hasn't been falling for the past few months. But Fed Chair Powell really seemed to indicate that he believes the fed funds rate is high enough to do the job of bringing inflation down longer run and that they're just going to be patient and wait for that to happen. You know, that was a bit of a relief to the market since there had been some chatter about the possibility of a rate hike. Powell didn't rule it out entirely, but he sounded pretty confident in inflation falling over time. 

One new thing is that the Fed is going to begin tapering its quantitative-tightening policy starting at the end of May. Again, not a big surprise. 

LIZ ANN: But it was a little more than expected, right, in terms of the shift in what they're letting mature.

KATHY: Yeah, so for people who aren't as familiar with this, quantitative tightening is when the Fed reduces its balance sheet by letting bonds mature without reinvesting the proceeds. And that allows the balance sheet to come down kind of gradually. They are reducing the amount that they're allowing to run off from 60 billion to 25 billion in the Treasury market, but they haven't changed the amount in the mortgage-backed securities. And in the mortgage-backed securities, when they mature, they'll be reinvested in Treasuries. So that's their way of trying to get those holdings of mortgage-backed securities off their balance sheets sooner rather than later. Fed is not happy with being in the mortgage business. I don't think they thought they would be still in the mortgage business at this stage of the game, and they're happy to let that roll off. 

But I think the key point here is that what the Fed's doing in the balance sheet is really not about interest rate policy or even the economy or inflation. It's about making sure there's enough liquidity in the financial system. And the impact of quantitative tightening has never been as significant as the impact of quantitative easing.

So my take on it is, OK, they're doing this, they're moving ahead with the plan, but the likelihood of it having a big impact on the market are pretty slim. Couple of things from the tidbits from the press conference, Powell indicated, again, he thinks policy is restrictive. That's how the Fed talks about its policy. "Is it restrictive enough to bring down inflation?" And he said yes, they believe it is.

And he downplayed the idea that the next move would be a rate hike. So overall, I think the message is, you know, "We're on the right path. We'll continue with this policy for the time being. And just be patient." Bond market was really happy with the messaging. Yields fell across the curve. I think going into the meeting, expectations had built up that this might be a hawkish message from the Fed. And we were down to only discounting one rate cut this year.

Now it's back to close to two, so I think the earliest we could look for it is July, maybe September and December would be likely time for cuts. It all really is going to depend on how inflation develops and how the economy does, if there's any particular issues in the financial system, that would be a motivation, and of course in the job market, which is very important.

But I think a lot of traders and investors were braced for bad news, and when it didn't materialize, you know, the bond market rallied. The stock market had a little bit more confusing reaction—it rallied at the beginning and then proceeded to sell off. What do you what do you make of that, Liz Ann?

LIZ ANN: A fickle stock market? What? Do tell. So you know, there has been so much focus on the movements in the market and at times seeming resilience on the part of the equity market, given the changing expectations around Fed policy from the January expectation of a start in March and up to, you know, six or seven rate cuts, which didn't seem to make a lot of sense at the time, but that's what the market was expecting. And then this shift—to your point, Kathy—of now expecting maybe not even two at this point. I think what's been driving the market, driving volatility shifts, as well as importantly, shifts in terms of leadership, whether it's small caps versus large caps or cyclicals versus defensives, is less about expectations around Fed policy and more about what Treasury yields are doing. And to use the 10-year as an example, particularly since the summer of last year, you had the big move up in the 10-year from 4% to 5% from late July to late October, and that directly corresponded to a 10% correction in the S&P 500 and a little bit more for the NASDAQ. And then at the end of October, and you saw yields peak, and the 10-year went from 5 down to sub 3.8%, that provided a huge tailwind behind stocks broadly. It provided big support for small caps and more beleaguered companies. But then the move back up, initially, it was just to the detriment of smaller cap companies, the zombie-type companies that are much more at the mercy of changes in interest rates in terms of their funding and rolling over debt. The large companies don't tend to be as impacted. But as yields continue to move higher, and you recently touched above 470 on the 10-year, I think that was part of the reason for some of the overall weakness at the index level, but a lot more of the underlying weakness that we've seen, especially an index like the NASDAQ. 

You and I have talked about this before. I think a really fascinating story about what's going on in the market is seen more under the surface, not at the index level. The NASDAQ's only had about a 7% drawdown from a year-to-date high. That's not even at official correction territory, but the average NASDAQ member has had an average 33% drawdown. So that's bear-market-level weakness. It's just happened through a process of rotation, but where you see kind of the hits and the misses and where leadership shifts have occurred between cyclicals and non-cyclicals up the cap spectrum, down the cap spectrum, has a lot to do with what's going on in Treasury yields. So I continue to think that your world to some degree is in the driver's seat of my world. And at least until we have a little more clarity on Fed policy, I think the bond market as a driver of some of the moves, both on the surface and underneath the surface in the equity market, that's likely to continue to be the story.

KATHY: Yeah, bond market likes being the driver's seat. So that's OK. But at this stage of the game, I think, yeah, we could look at a little less volatility in rates for a while. And that actually might be a bit of relief for other markets. At least, you know, expectations may not shift quite as quickly as they have. I will have to wait and see how the data play out. Obviously, if we get some surprising data, things are going to change in terms of expectations on rates. But one of the things I have noted recently that I'd love to get your thoughts on is huge drop in commodity prices. Everything from crude oil is now back below $80 a barrel. Cocoa, which had been skyrocketing, has now corrected quite a bit. Pretty much across the board, we're seeing some softness in commodity prices, and that should be a disinflationary signal, although it's going to affect parts of the stock market, I assume.

LIZ ANN: Yeah, so one of the outperform ratings that we have at the sector level, and as a reminder to listeners, Schwab relaunched what we call our Sector Views earlier this year after about a two-year hiatus. And the hiatus was for a number of reasons, including just rampant sector-related volatility during the weird COVID period that was not defined, for the most part, by fundamentals. And we decided to put it on hiatus at the same time the folks behind the engine that drives Schwab equity ratings, which is the engine that drives the quantitative part of our Sector Views, was also perfecting the model, maybe not perfecting, nothing is perfect in this world, but our three outperform ratings that we launched, or relaunched Sector Views with, actually haven't changed since the beginning of the year, and they're financials, materials, and energy.

So materials and energy, obviously, are two sector-related plays on what had been a pretty significant surge in commodities, which, from a fundamental-backdrop perspective probably had some to do with some of the stabilization that we've seen in global growth—as our colleague Jeff Kleintop believes, the emergence out of a fairly mild recession in Europe and maybe even some signs of some bottoming in China with a little bit of improvement in their PMIs[1]. But I also think it reflected just general risk-on behavior in advance of this recent pullback phase for the equity indices. And to some degree, it brought some commodities down with it, even precious metals. So I think some of it was really down to technicals and sentiment, maybe a bit of an overbought technical condition, a little bit too much frothiness in the sentiment. And that can happen in other asset classes. We know sentiment is always focused on with regard to the equity market, but it can come into play in commodity markets and currency markets. So I think it's too soon to suggest that there's some significant shift in the trend there. Some of it may have just been technicals.

KATHY: Yeah, I think commodity prices tend to swing pretty widely from time to time, you know, overreach and then have to correct. Yeah, we'll have to see how it plays out, but it has been kind of a notable shift over the last week or so. 

LIZ ANN: Hey, Kathy, can I ask you a question? 

KATHY: Sure. 

LIZ ANN: You and I and any of us that go on the road and speak to clients always get the debt-and-deficits question, especially these days, but I would love to ask you how you're answering it lately, specific to things like Treasury yields and demand for Treasuries and whether we face any kind of liquidity constraints related to the ever-rising burden of structural deficits and debt.

KATHY: Yeah, the way I generally look at it is that "Yeah, of course it's a concern," because our debt and deficits are rising pretty rapidly. The debt shouldn't really grow faster than the economy if we want it to be sustainable over time. We look at debt-to-GDP, and it has been coming out of COVID. But frankly, since 2000, when we had a balanced budget, we have been, you know, cutting revenues with tax cuts and raising spending. And we have been doing this for a long period of time. Obviously, the pandemic has exacerbated it, and now we're doing things, you know, investing in the future with the CHIPS Act, etc., which is increasing the deficit. The good news is, at least for fiscal 2024, it's likely not to be any higher than in 2023. It might actually come down a little bit. So that's good news, but clearly, we need to address the trajectory of where we are. But when it comes to Treasury yields, I've said this a million times, there's no strong correlation between the amount of debt issued and yields. And I know that's counterintuitive. More supply should mean a price change. But when you look at correlations in short-term, intermediate-term, long-term, it's just not there because other factors are at work.

And interestingly, I just looked at the breakdown of who buys Treasuries, who's been buying Treasuries at these yields. And it's generally the same buyers have increased the amount that they bought, but the big rate of change has been in both domestic and foreign households. So they have greatly increased their purchases. And look, with yields at 5%+, it's not surprising people are buying Treasuries, either through a money market fund or a mutual fund or just outright buying Treasuries. And it's not just domestic. It's global because U.S. rates are so far above those in the rest of the world. So you know, I would say I can't put a timeframe on sustainability per se, but I could say it sure doesn't look like we're having any trouble attracting buyers. We're continuing to have people, you know, look at the U.S. Treasury market as a safe haven, a place where banks, insurance companies, pension funds, foreign central banks, you know, really need to have exposure. And then households have been, on the margin, willing at these yields to step up.

LIZ ANN: Thank you. I like it from the perspective of the fixed-income side of things, too.

But you're absolutely right. In a perfect world, you have debt growth lower than economic growth. But maybe that's pie-in-the-sky at this stage. Because then you start to chip away at the problem. And clearly, we're not chipping away at the problem much. But I think the investor class cares a lot about this issue. And I hear it all the time. I'm not sure the average constituent cares all that much, which may be why there aren't serious conversations being had about the long-term sustainability of this. I don't know what changes that.

KATHY: I do think that, you know, average constituent cares in the abstract, but when it comes down to the particular, nobody wants to pay more taxes, and nobody wants to cut the things that, you know, benefit them, whether it's Medicare, Medicaid, Social Security, veterans benefits, you know, these are the things we spend most of our money on. Defense. Everyone's in favor of keeping those programs and increasing spending. So people care in the abstract, but when it comes down to the particulars, yeah, they're tough decisions to be made.

LIZ ANN: Yeah, NIMBY, not in my backyard. Cut somebody else's stuff, not mine.

KATHY: Right, exactly. 

So Liz Ann, anything else on your radar right now that you're focusing on?

LIZ ANN: Well, obviously, the data, as you and I are recording this, it's in advance of the monthly jobs report, which comes two days from this point. So especially in the aftermath of yet another hotter-than-expected set of inflation readings and, of course, the FOMC meeting and everything discussed at the press conference, the labor market data is important, but we don't have the data, so we can't. But that's certainly going to be much of the chatter toward the end of the week.

You know, I think some of the innards of the consumer confidence report that was out this week from the conference board were interesting in the sense that the present situation component has kind of hung in there, but there's been a notable deterioration in the expectations component. So to put it in simple terms, "I feel OK right now, but I don't expect that I'm going to feel great about the economy or my own set of circumstances."

And the spread between those two, yet again, is down in pretty clear recession territory. Now, it's been an indicator that's been in recession territory, and we haven't gotten it. The decline in leading indicators has been in recession territory, and we haven't gotten it. You know, the yield curve, the list goes on. I still think we've gotten recessions in parts of the economy, just not across the board. But next week, we get consumer sentiment out of University of Michigan, and that tends to be biased a bit more by what's going on in the inflation backdrop. So that'll be interesting to see if some of the data corroborates what we saw with consumer confidence. And then we get the next week also the SLOOS data, the Senior Law and Officer Opinion Survey. And it's not quite as in the spotlight as it was a year ago when we had the mini banking crisis, but as a way to track the lending backdrop and financial conditions and their tightness, that sometimes can have some interesting tidbits in there.

And what about you, Kathy?

KATHY: Yeah, I'm watching all the same stuff. Obviously, I did think the JOLTS report, the Job Opening Turnover Labor Supply report, was interesting because we do look at that quits rate, people voluntarily leaving their jobs, and wage growth. And there's a pretty tight correlation there. And what we've seen is that quits rate come down to a level that's more consistent with maybe 3% wage growth instead of 4 plus. And actually, Fed Chair Powell did cite that report as one reason he feels that inflation will come down because wage growth is slowing down. So I'm going to keep a pretty close eye on some of the underlying things that we find out about the labor market even after the report.

You know, one of the things I love to do is read these regional Fed reports. And one of the things that we see is a kind of soft tone in those and indications that they're not hiring as much, and they don't need to pay as much. And that kind of contrasts with some of the worries people have about inflation in the markets. I'm going to keep a pretty close eye on that and see what we can glean from that. And then, of course, we are going to have, you know, the quiet period is over.

So now Fed officials will be out in full force, no doubt. 

LIZ ANN: The Federal Open Mouth Committee.

KATHY: That's right. They'll be out, and who knows what they're going to say. Will they back up what Powell has to say, or will they go another direction? I mean, this is always a wild card. So definitely keeping an eye on that one as well.

LIZ ANN: Hey, on that subject, what is your view? There's some thinking, and maybe he's inferred it or even mentioned it, although I haven't heard it, that when Powell decides he wants to consider cutting rates, that he wants the decision to do so to be unanimous. Do you think that that's valid? Do you think he's kind of digging his heels in and saying, "We're only going to do this when it's a unanimous decision on the part of the voting members"?

KATHY: No, I don't think it's quite the case. I think the delay is just data driven, that they really, really, really want to be confident before they start cutting rates because they don't want to repeat the mistake of the '60s and '70s. But he actually got a question about those unanimous votes and whether that signals anything. And he kind of danced around it a little bit, but basically said, "No, it's a matter of us getting enough confidence, but we have a diverse group of opinions out there, and they're all respected, but we may get some dissents from time to time, but we talk it all out," and I guess it's sort of a kumbaya thing. By the end, they all tend to agree with the wording of the statement and how they're framing the story. But yeah, I think the first cut, it would be tough not to have a unanimous decision. If it were midstream or towards the end of a cycle, it would be more likely as people seeing things differently. But the first cut, I think, will be a unanimous decision. 

LIZ ANN: Yeah, I agree with you. I wanted to just add something to what you were discussing before we just got on this tangent, which is some weakness starting to show up in the regional Fed surveys, especially with regard to things like hiring intentions. And where you're also seeing that show up is in the NFIB survey that's done, the National Federation of Independent Business, which is a tracker of small businesses. And it's really where a bifurcation is opening up. You see it to some degree in the equity market with the bias in performance up the cap spectrum in the larger companies. And it's pretty dour, things like hiring intentions and compensation plans at that small-business level. And given that in net terms, they're the largest job creators, that is something to keep an equivalent eye on in addition to things like monthly jobs reports or ADP-type data, which by their nature tends to be more biased toward the larger companies. So that would just be another set of data points to keep an eye on to really get a true sense of what the outlook is for the labor market.

KATHY: Yeah, that's a great point. 

LIZ ANN: Well, you and I could sit and talk Fed for a long time, but I think we'd be down to about two listeners, and it's probably both of our husbands, so we'll leave it at that for now. But this topic is not falling into the eaves. This is going to be a big focus for us and everybody that's a market watcher, but that's it for us on this episode, and as always, to all of our listeners out there, thank you so much and remember you also can follow us on social media where we will also link to these episodes. I'm @LizAnnSonders on X, formerly Twitter, and LinkedIn.

KATHY: And I'm Kathy Jones, @KathyJones. That's Kathy with a K on X, formerly known as Twitter, and LinkedIn. Be sure to follow us for free in your favorite podcast app. And if you've enjoyed this episode, tell a friend about the show or leave us a rating or review on Apple Podcasts.

LIZ ANN: And next week, we have a really, really special episode for you. I am going to be sitting down with and speaking with the man, the myth, the legend, the name in the blue box on our signs, and just happens to be the founder of our firm, Chuck Schwab. I've known Chuck for a long time. I'm celebrating my 25th anniversary at Schwab this week. So I'm really looking forward to it.

He's always fascinating to listen to: the history of Chuck founding Schwab 50 years ago in San Francisco at a time where he was a disruptor and couldn't rely on traditional Wall Street. So I'm really looking forward to our conversation. I think everybody will enjoy it. So stay tuned for that.

For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.

[1] Purchasing Manager's Index