Key Signals from the Fed & How to Manage Risk

LIZ ANN SONDERS: I'm Liz Ann Sonders.

KATHY JONES: 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.

KATHY: Well, Liz Ann, it's been a shorter week with Martin Luther King Day Monday, giving us a little bit of a holiday. But been really, really cold across the country. I've been talking to my relatives in the Midwest, and it's definitely in the deep freeze.

And you know, I would say our episode today is shorter than usual as well, but there's no shortage of topics to discuss when it comes to the market. So it's just you and me. What's on your mind today?

LIZ ANN: Well, it's been cold here in Florida too, but I'm always really careful about not complaining about that in a week where you've had "real-feel" temperatures in the minus double digits. So but the fact that it hasn't gotten out of the 60s on some days in relative terms, that's cold. It was nice to have a short week. I always joke that I think given how much we all work during the day, if we could condense it into four days every week and have every weekend be a three-day weekend, it'd be nice, but I don't I don't think the New York Stock Exchange would oblige, and you and I are somewhat beholden to market hours, but yes we're going to give our listeners a little bit of a reprieve given that I think the prior episode was a bit long—although meaty with content. I think we just want to let our listeners in on just a conversation between you and me on some fairly interesting topics.

KATHY: Yeah, I think today: three main issues. One is, I want to review Fed policy, including some of the new developments that are taking place in terms of the Fed's balance sheet. So we can fold in our view on inflation into that conversation.

And then another topic that I think is always interesting is how you focus on risk, how you manage risk in a portfolio. I think it's something we both think a lot about, but we don't necessarily talk about it all that often. And then the third thing, I think in what's going to become a regular segment of the show, I hope, is some reading recommendations. What we're listening to, what we're watching, what we're reading.

I think that's going to be kind of a fun addition to our usual conversation.

LIZ ANN: So we want to start with the Fed, which is always an interesting topic, but particularly this year as the market has an expectation of a Fed not just through their words pivoting to eventually easier policy, but a market that actually expects a pivot as early as possibly March, although with every incoming data point, that does adjust a little bit. So that's where we're going to start with the Fed. Kathy, you mentioned new developments and tied it into the balance sheet. So explain what you meant by new developments and let's start there.

KATHY: Yeah, Liz Ann, I know this gets a little bit into the weeds for a lot of people, but there are a couple of policies that the Fed has had in place for a while that it looks like are going to end. And that's significant in terms of what it tells us about where the Fed is going. So one is quantitative tightening. This is where the Fed is reducing the size of its balance sheet by letting existing bonds mature and not replacing them. And the other is this Bank Term Funding Program that was put into place during the crisis around Silicon Valley Bank, etc., that allows banks to borrow money directly from the Fed at a good rate in order to make sure they have enough in the way of reserves and funding. These are two important things, because both seem to be moving towards reduction or conclusion.

So in terms of quantitative tightening, again, this is the process of allowing the balance sheet to decline. As you know, it's already fallen by more than a trillion dollars from its peak in the past year. And at the current pace, it probably will drop another trillion by 2025, but it looks like the Fed is preparing to slow down that pace. And the reason is that this is going to be in conflict with its easing policy once the Fed gets around to cutting rates. So when the Fed increases the balance sheet, it adds money to the economy. When it reduces it, it subtracts money, broadly speaking to the financial system, which flows through to the economy. So the Fed needs to adjust its balance sheet policy and probably is a good idea to do it ahead of starting to cut interest rates. And I think what's important there is what it tells us is the Fed is planning to cut rates, right? 

Then we had a couple of speeches from very important people at the Fed, including Lorie Logan, who's now the president of the Dallas Fed. She was formerly the head of the markets desk at the New York Fed, which is the desk that manages all of this process. She's the expert there. And she kind of laid out a plan that would allow the Fed to reduce the pace of quantitative tightening. So I would expect they'll make that announcement in March and then think about cutting rates starting maybe at the May meeting. So this is an important signal to the market. I think it's something that we should take pretty seriously. 

In terms of the Bank Term Funding Program, that is scheduled to run out in March. It doesn't mean an abrupt end to the bank's ability to borrow from the Fed. These are one-year loans, so the banks will still have that funding for another year. But it also is kind of closing the door on some of these special things that were meant to boost the financial system. 

Speaking of the Fed, last week on the show Claudia Sahm made a point of reiterating that she believes the Fed will get us back to 2% inflation. Liz Ann, what are you seeing in the data right now? Do you think that that's a realistic expectation versus what's maybe priced in for 2024?

LIZ ANN: You know, in terms of the data, we're seeing a little bit of everything. Even individual reports have a lot of sort of meat on the bones and cross currents, and that's kind of been the name of the game in this unique cycle is the cross currents. And it can be seen in the differential between what's going on in the manufacturing side of the economy versus the services side of the economy. You see it in the pretty wide spread between what are called soft economic data releases, so survey-based data versus what the actual hard numbers are showing, even soft versus hard that would seem to be directly connected, things like consumer confidence, having been fairly weak in this cycle, yet consumer spending quite a bit stronger in this cycle. And then, you know, another example of on the surface, things look good, but then underneath, it's a bit murkier. You saw that with the December jobs release, which had a better-than-expected payrolls and no change in the unemployment rate. But the details were a bit murky or saw a big drop in household employment. You saw a fall in the labor force participation rate. And that was the reason why the unemployment rate didn't go up. That's sometimes considered the bad reason for an unemployment rate not moving up. But you saw slightly hotter than expected wage growth, which that's great for workers. We're not dissing stronger wages, but from the perspective of the Fed and their timing and what factors they're looking at to judge that inflation will continue to come down eventually to or near their target and stay there, that's certainly something they have kept a close eye on. You get all these regional Fed indexes that in some cases are split between readings on manufacturing and readings on services.

We saw a really somewhat disastrous drop in Empire, which comes out of the New York Fed on the manufacturing side, yet the services side was fairly resilient. We'll get a number of additional regional Fed indexes next week. And then most recently, as you and I are taping this, we had a stronger than expected retail sales report, including the various core measures of retail sales, one of which is called the control group, and that feeds directly into GDP. 

So I think the collection of data is in support of what we view, and my thinking is in keeping with your thinking. I think it may be, given what we know now, a bit too aggressive to assume the Fed actually starts cutting in March. And in the aftermath of the release of retail sales, you did see probabilities drop a week ago or so. I think they were at about 65% probability of a cut. Now it's down. I think last I looked was around 57% probability. So it does show that with each incoming report, you can see the needle move in terms of expectations for Fed policy. So you know, we talked a little bit about the inflation readings that have come in with slightly hotter CPI. So Kathy, what are your thoughts on kind of the near future in terms of either upcoming inflation reports or, just as importantly, inflation expectations, which I know is something you keep a close eye on.

KATHY: Yeah, I think the good news is that the inflation expectations have been really pretty tame throughout this cycle relative to the amount of inflation that we've gotten. Expectations really didn't move up as much. There was always a big gap between the actual reading on inflation and where expectations were. And I think that gives you a sense that there is confidence that the Fed will get inflation down in the future. That's what the market at least is telling us. The other good news on inflation is the—I keep an eye on the wholesale inflation numbers, as do you—we got import-export prices. Those have been falling for well over a year. Every month we get a negative reading there. Some of that has to do with energy prices being down.

But there's also a lot of, at the wholesale level, a lot of softness in prices. So what we're really left with, I think, is this, as you mentioned, the service sector's still doing well and having some pricing power, but the manufacturing sector and exporters of raw materials just not having that pricing power. So I think eventually those probably converge in a lower level of inflation. I think that that's probably where we're headed.

And I do take the view that if the Fed wants to get inflation down, it will get inflation down. It's always just a question of what the tradeoff is in terms of slowing the economy. 

LIZ ANN: Hey, Kathy, I want to get your thoughts on a more recent development, given what's going on in the Red Sea and the fact that the last couple of weeks we've seen an 85% increase in global shipping costs. It's sort of one of those wild-card geopolitical issues that I think could cause, at times, some shorter-term inflation volatility. So how do you see events like that, and the risks associated with that, as it relates to your longer-term view on inflation?

KATHY: Yeah, my view is that these are those kind of one-off exceptions that, as you say, raises the volatility of inflation but doesn't change the trend. So it seems unlikely that unless demand is so exceptionally strong relative to what we believe it is for a lot of this wholesale goods, that increase in price will just flow right through to the buyers and at the consumer level.

I think it's something that probably will have to be absorbed by some of the companies doing this shipping. That being said, it can take a while and can be very disruptive in terms of the trend. And so I think it's a disruption, but not a trend changer, is how I would view it.

So I wanted to ask you a bit more about the second topic here, which is one that I think about a lot, and I know you do. How do you think about managing risk in a portfolio? We talk to clients all the time and we give them our best thoughts and our guidance, but what do you take into consideration from a risk perspective when you're talking to clients about their portfolios?

LIZ ANN: So I'm sure we'll talk about the overarching most important sort of first-step parts of the process that I think need to be considered when assessing risk and how to keep it to a minimum, which is things like strategic asset allocation and making sure that is tied to your own individual set of circumstances, your risk tolerance, time horizon, need for income, etc., etc. 

But on the … just the risk tolerance piece of it, what I have found in talking to many of our investors is that… and unfortunately, they often find this out the hard way, not the easy way, is that there's the concept of financial risk tolerance. Let's think of that as what if you're sitting with your advisor, your financial consultant, and developing a plan and assessing your financial risk tolerance, which is the risk tolerance, effectively, you know, air quotes "on paper," again, tied to time horizon and need for income, the various tax implications, goals for the money that you are investing, that's your financial risk tolerance, but then there's the emotional risk tolerance, and sometimes there's a fairly narrow gap between those two, and sometimes there's an incredibly yawning gap between those two. And if it's a yawning gap, it's often discovered the hard way, meaning on paper, your financial risk tolerance appears to be fairly high, either maybe because you have a long time horizon, you don't need to earn income on that money, but the emotional risk tolerance comes into play when you have the inevitable losses in portfolios.

And what that can lead to in terms of maybe triggering a sale at the wrong time. And it can work in the other direction too—they're performance chasing and the greed factor, not just the fear factor. So I think that's one of the most important things to address initially is the differential, if you can perceive it without learning the hard way, between that emotional risk tolerance and that financial risk tolerance. 

And then, of course, and this carries over into your world on the fixed income side, too. You know, we talked about strategic asset allocation, the exposure you have to various asset classes, understanding which asset classes are positively correlated, negatively correlated. Diversification is always an important risk factor to consider, and that's both across asset classes, part of the exercise of developing an asset allocation plan, but also within asset classes. And then the last one that I don't think gets enough attention as a benefit from a risk tolerance perspective and even a return perspective, which is periodic rebalancing. I think rebalancing is such a beautiful discipline and exercise because it essentially forces us as investors to do what we know we're supposed to do, which I like to say is a version of "buy low, sell high" but is really "add low, trim high." And it means your portfolio essentially is telling you what to do. Asset classes or even individual securities that have become outsized weight in a portfolio—that is sending a message that you maybe want to pare that back. 

So you're taking those profits and adding to areas that perhaps have underperformed and have become a lower weight in your portfolio. And often when left to our own devices without that discipline of rebalancing, we tend to do the opposite. We chase on the upside. We keep our winners and let them get larger and larger as the share of the portfolio, and conversely, we often panic and sell the losers and end up getting out of balance, which is not to the benefit of mitigating risk.

I know you think of it in many of the same ways, Kathy, as it relates to things like asset allocation, but what maybe is unique about the way to handle risk on the fixed income side of things?

KATHY: Yeah, you make a lot of good points there, especially the behavioral one, right? That we think we have a certain risk tolerance and then when reality hits, maybe we don't. We see that a lot with investors. I feel that myself from time to time. I have to sort of stop myself from overreacting. And I think there's the risk capacity issue as well. It's one thing to say, "Yeah, I'm a big risk taker. Everything's fine." And then realize that, "Oh, wait a minute, I'm going to need my money in the next 12 months. Maybe I don't have the capacity to take that risk right now that I might if I had a longer time horizon." So those are great points. You know, in the fixed income side, there are a couple of dimensions that are important. You have both interest rate risk and credit risk, and those are two things to balance. So what happens to my bond portfolio when interest rates rise or fall versus the risk that a bond issuer might default? 

So we have to look at the trade-off between those two, between taking a lot of risk, say, in high-yield bonds for the higher yield, only to find out that I have a much higher risk of default and losing capital. So we tend to lean more towards the cautious side in our guidance because most investors don't look at their bond portfolios as the place where they want to take a lot of risk. That's generally for equities, but there are other things to consider. One, and this harkens back to my days when I was in a trading role, one thing to think about as well is just sizing your positions. You know, are you allocating the right amount to riskier assets, or are you overdoing it? That can make a huge difference in terms of your staying power.

So we know people who get very enthusiastic about an asset class. They go heavily into that asset class. It might work out well in the beginning, and then it goes against them, or vice versa. Do you have the staying power in that? And if you want to take a certain amount of risk, make sure it's sized appropriately that you can withstand the volatility that comes with that and the potential capital loss.

Also, of course, diversification within asset classes. You mentioned that. It's the same story for fixed income. You know, we wouldn't suggest people have half their portfolios in one stock. It's the same in the bond market. Have some diversification of issuers, of time horizon, of maturities, and that all helps to mitigate some of the risks.

I'm going to switch to our third topic this week. So I wanted to go back to a question that we talked about in our second episode, and that is "What are you reading? What are you watching? What are you listening to? Do you have any recommendations?" I'm always looking for things to keep myself busy and engaged. So what about you, Liz Ann? What are you reading these days?

LIZ ANN: I'm more of a listener than a physical book person. I love air quotes "reading books," but I tend to do it via the audio version more often than not, only because it allows for multitasking, obviously. Whether it's taking a hike or riding a bike or making dinner or whatever it is, driving. I like the fact that I can stay in a book more regularly. The physical act of sitting down with a book, my time is limited because, much like you, we're every day we're drinking from a fire hose of day-to-day information and research that we need to absorb just to do our jobs effectively that the time it takes to sit down with a kind of a hardcover book … although my husband just finished reading the Michael Lewis book on Sam Bankman-Fried, Going Infinite, and he breezed through it and said it was fascinating. So that may be one, since we already own it in hardcover, I might not pay the money to also do it in audio. I'm a huge podcast listener. It was one of the reasons why I was so enthusiastic about starting this. Some of them are around the world of investing and the macro environment. Grant Williams, who is a friend, I've done his podcast before, but he has a number of podcasts, his flagship Grant Williams Podcast, but he does one called Super Terrific Happy Hour with Stephanie Pomboy, who is a very interesting macro analyst, Kaos Theory, The Narrative Game. So those are fascinating. Some of the shorter, quicker, more in-the-moment, Motley Fool has some interesting podcasts as well. 

But there are a couple that are outside the world of investing. If I really just want a fun listen, I'm a huge, huge, huge fan of Smartless, with the brilliant trio of Jason Bateman, Sean Hayes, and Will Arnett. And it's just so fun and infectious. And then the one my husband introduced me to that I've just started to listen to episodes, and it's really fascinating if you're sort of a history buff, which I know you are, is Hardcore History. And it's just a very interesting take on really all of history, but in a way that is very digestible. So what about you, Kathy? What are you listening to or reading?

KATHY: Well, I have to admit I'm more old-fashioned. I like having a book. I feel like I stare at a screen all day long. And I would rather not stare at a screen in my free time. And I'm also guilty of actually just reading whatever is in front of me, from The Economist to my mother's craft magazines. So I'm kind of all over the place.

But for work, the last thing I've been reading is, just a couple of days ago, are the transcripts of the Fed meetings from 2018. You know, they're released with a five-year delay. And so it's very interesting to go back and kind of see where was the Fed at that time period. This was pre-pandemic, coming out of the great financial crisis, very different kind of environments. Really interesting to kind of go back and see what the mindset was and what was top of mind for them. 

I'll name a couple of books that are not necessarily real recent, but I have found really engaging. One is Dead in the Water. It's by two Bloomberg reporters with the last names of Campbell and Chellel. True-life murder mystery that tells you a lot about the global shipping industry and how it operates. Not always the prettiest picture. But given the recent focus on the events in the Red Sea that you mentioned, I think a lot of people would find it very interesting. 

And then another one for people interested in econ history, Jeffrey Garton's Three Days at Camp David. It's a fly-on-the-wall look at the time period in 1971 when the U.S. changed its policies on the dollar, tying its value to gold. It changed the global financial system in a huge way, and it happened in a really short period of time. There were a lot leading up to it, but it's a great sort of economic history tied in a way that's very digestible for people so you don't have to be really down and into the nitty-gritty. It's very understandable. So those are a couple of books that I really enjoyed. I think people listening might enjoy as well.

LIZ ANN: You know, I'm glad you mentioned reading the Fed minutes. I'm going to have to put that top of my list because that was such an interesting year. I remember attending the luncheon at which Jerome Powell spoke in December of 2018 at the New York Economic Club, and it got a lot of attention because it was seen as the point at which he essentially backpedaled relative to what he had said in September that had kind of roiled markets. But having been there in person, what I found more interesting that he said, which didn't get as much attention, was the distinction he made between financial system stability and financial market volatility, and that the Fed's mandate was not to step in at every point there is financial market volatility unless it's part of the risk of financial system instability. And I don't know, that was just one of those things that resonated with me, even though the takeaway from reporters in the room was the perceived backpedaling relative to what he said in September. So I'm going to have to see what the minutes were saying at that time too because I still have such vivid memory of that.

KATHY: That's great. I do remember that moment. I wasn't at the event, but I do remember that moment. And I think the Fed always tries to do that. They always try to focus on "What's the transmission to the real economy? Do we need to do anything about it?" I'm not sure they've always lived up to that standard, but yeah, definitely something that they talk a lot about.

LIZ ANN: And with that, we are going to wrap it up for this episode. As always, thank you for listening, so much.

KATHY: And if you want to keep up with the charts and data we post in real time, you can follow us both on Twitter (or X) or LinkedIn. I'm @KathyJones, that's Kathy with a K on Twitter and LinkedIn.

LIZ ANN: And I'm @LizAnnSonders, and that's S-O-N-D-E-R-S. And if you've enjoyed our podcast so far, it really does help if you go on Apple Podcasts and leave us a rating or review.

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