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WashingtonWise Investor: Episode 37


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Inflation Fears: Real or Overhyped?

Kathy Jones, Schwab’s chief fixed income strategist, joins the podcast to consider how an improving economy may be the real driver behind rising rates and how the Fed plans to keep the momentum going.   

In this episode of WashingtonWise Investor, Mike Townsend is joined by Kathy Jones, Schwab’s chief fixed income strategist, to look into what’s driving up long-term interest rates, the Fed’s outlook on inflation and economic growth, and the impact rising bond yields are having on the equites market. Additionally, Kathy shares her insights on the improving opportunities with municipal bonds. 

Mike also considers how Washington is catching its breath and considering what’s next now that the massive economic stimulus bill is law. And he provides updates on the IRS—finally—moving Tax Day, frosty U.S.-China talks, the latest in a series of Congressional hearings on social media-fueled retail trading frenzy, and the low chances of success of some high-profile tax proposals.

WashingtonWise Investor is an original podcast from Charles Schwab. If you enjoy the show, please leave a rating or review on Apple Podcasts.

Click to show the transcript

MIKE TOWNSEND: As spring 2021 gets underway, it feels like everything is picking up momentum.

The cherry blossoms are on the verge of blooming here in Washington, with the azaleas poised to follow.

The Biden administration’s plan of 100 million vaccine shots in its first 100 days seemed audacious a few weeks ago—but that number was exceeded in just 58 days.

As of Monday, March 22, all 15 of the president’s nominees to be Cabinet secretaries had been confirmed by the U.S. Senate.

More than 90 million economic stimulus payments had been made by the end of last week, with another batch sent by the IRS earlier this week.

And, of course, it’s March Madness time, as college basketball’s season-ending tournament has already whittled 68 men’s teams and 64 women’s teams down to a pair of Sweet 16s.

But while all of that is going on, it also seems like Washington is taking a bit of a pause for the first time since the chaotic events of January.

Welcome to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to cut through the noise and the confusion of the nation’s capital and help investors figure out what’s really worth paying attention to.

This week, I’m joined by Kathy Jones, Schwab’s chief fixed income strategist, who is going to help us make sense of the improving economy, rising yields in the bond market, inflation fears, and how the Federal Reserve plans to keep it all going. That conversation is coming up in a just a few minutes.

But first let’s take a look at some of the stories making news right now.

The past two months have moved at a dizzying pace in Washington, with the inauguration of a new president, the impeachment of the previous president, and a seven-week sprint to pass one of the largest stimulus bills in the nation’s history.

Next week, both the House and the Senate will begin a two-week recess on either side of the Easter holiday. And when lawmakers return in mid-April, it will be to a less chaotic pace—lots of hearings on Capitol Hill, the start of the budget and appropriations process for the next fiscal year, and what I expect to be a long and meandering process to develop the next big spending bill.

The Biden administration has made it clear that that bill should focus on infrastructure and green-energy spending, and that it should include increased taxes on wealthy individuals and corporations to pay for it. And the White House has indicated that it is willing to use the budget reconciliation process if necessary to get the bill done. That’s the special set of rules that prohibits filibusters and allows a bill to be passed in the Senate by a simple majority vote. It’s the mechanism by which the economic stimulus bill was approved earlier this month.

But that’s about the sum total of the decisions that have been made on this bill so far. Expect Congress to spend weeks—or, more likely, months—trying to put an infrastructure package together. Expect it to be messy and complicated and to seem like it’s all going to fall apart multiple times along the way. The goal is to pass it by mid-summer, but a more realistic timetable might be early fall.

Now Congress will of course be passing other legislation in the interim—Democrats have a long list of priorities to pass through the House of Representatives, many of which may find it much tougher sledding in the 50-50 Senate. The bottom line—the economic stimulus bill was approved in seven weeks, an extraordinary timetable for a bill of that size. Expect the next big legislative initiative to take much longer.

Elsewhere, last week saw the third Congressional hearing in less than a month looking into the retail trading frenzy a few weeks back that saw extraordinary volatility in a handful of companies, including GameStop Corporation. Much of the trading was fueled by retail investors who follow Reddit message boards and other social media sites to try to find the next hot stock.

The hearing last week was mostly academics and other market experts opining about whether new regulations are needed in response to the volatility. There was considerable discussion about whether it has become too easy to make complex and risky trades via a smartphone and whether more education and disclosure is needed to help unsophisticated investors better understand the risks they are taking.

There was also lots of talk about “payment for order flow” and whether retail investors are getting the best execution on their trades. There was talk about shortening the settlement cycle from two days to one. There was talk about whether short sellers are good or bad for the markets.

At the moment, it’s a lot of ideas and a lot of theories. But what hasn’t emerged from the three hearings is much of a consensus on what, exactly, should be done about any of these issues. And that underscores the complex dynamics that are at work when it comes to operating the largest capital markets in the world. Both the House Financial Services Committee and the Senate Banking Committee are expected to hold one more hearing each in the weeks ahead to continue digging into these issues.

What to conclude from all of this? Well, we continue to think that Congress is not likely to pass any legislation addressing these issues but will hand this all off to the SEC and let the regulatory agency decide what changes might be needed.

None of which is going to happen fast. The SEC is already working on a study of the late January market volatility in the so-called “meme stocks.” But the regulatory process is a tedious one that can often take a year or more. So this is another area where investors shouldn’t expect anything to change anytime soon.

Finally, investors may have seen headlines recently about a couple of high-profile tax proposals, and I thought it would be worth giving listeners a sense of the prospects of these two bills.

First off, earlier this month, Senators Elizabeth Warren and Bernie Sanders, along with six other Senate Democrats, introduced the “Ultra-Millionaire Tax Act.” The bill proposes a 2% tax on the net worth of households and trusts between $50 million and $1 billion, with an additional 1% surtax on assets over $1 billion. A companion bill was also introduced in the House of Representatives. This wealth tax was a key component of the presidential campaigns of both Warren and Sanders.

Does it have a chance in Congress? Well, it doesn’t appear so at the moment. There are a lot of questions about how difficult it would be to calculate and to enforce it. And there are even questions about whether such a tax is constitutional. Opponents also argue that it would discourage investment.

Significantly, the Biden White House has not endorsed the proposal. President Biden has said that increasing taxes on the wealthiest Americans and on corporations is a goal of his administration. But the White House has prioritized increasing the corporate tax rate and the top individual tax rate. For now, Warren’s wealth tax proposal does not seem like it has the broad support within the Democratic Party to make it likely in the near term.

The other tax proposal that has drawn some attention recently is a financial transaction tax. Last week, Senator Brian Schatz, a Democrat from Hawaii, along with five colleagues, introduced a bill that would impose a 0.1% tax on each sale of stocks, bonds, and derivatives.

The idea of a financial transaction tax has floated around Washington for a decade or more without ever really gaining much traction. This year, it has garnered more attention as a result of the uptick in retail trading activity that I mentioned a minute ago. Some lawmakers see a financial transaction tax as a way to curb overly speculative trading.

But like Warren’s wealth tax proposal, the financial transaction tax still faces a steep climb in Congress. In the 50-50 Senate, such a proposal is likely to need all 50 Democrats to be united behind it—and that hasn’t happened yet. And, once again, the White House has been cool to the idea, with officials saying that the proposal warrants further study, but stopping short of endorsing it.

For now, we think both of these proposals are relative long shots in the near term. But they’re both very much part of the discussion in Washington, and investors should keep an eye on developments in the months ahead.

On my Deeper Dive segment, I want to explore why fear of inflation is on the rise, whether that fear is misplaced, and what impact those fears, as well as nearly $2 trillion of economic stimulus, are having on fixed income investors. Joining me to help make sense of it all is Kathy Jones, Schwab’s chief fixed income strategist. Welcome back to the podcast, Kathy.

KATHY: Great to be here, Mike.

MIKE: Well, Kathy, let’s begin with last week’s meeting of the Federal Reserve. I don’t think it was any surprise that the Fed is going to maintain interest rates close to zero and doesn’t see an increase coming anytime soon. But what really struck me was how little the Fed seems to be worried about inflation—whereas the market and investors seem to be very worried about inflation. So where is the disconnect?

KATHY: Well, a lot of people are concerned about the divergence between the Fed’s view of inflation and the market’s view. And the market, I think, is having difficulty reconciling the Fed’s stance that it wants to keep interest rates low to stoke the economy with the fact that bond yields are rising. So, from the Fed’s point of view, they think any bump in inflation over the next year or so is not likely to last very long.

They see it as mainly due to some supply shortages resulting from the pandemic. Since production facilities were shut down, ports are only beginning to catch up with backlogged deliveries, and meanwhile demand has rebounded rapidly, so prices for some goods and services are rising due to these supply limitations. That’s an imbalance that’s likely to resolve itself in the next six to twelve months.

On the other side of the equation, we have eight to nine million people who are still out of work and a lot of businesses in the service sector that have yet to fully re-open. Those are forces that are likely to keep inflation low. And that’s the Fed’s biggest concern. Fed Chair Jay Powell has been clear that the Fed doesn’t want to raise rates until it sees unemployment back to pre-pandemic levels and evidence that inflation is actually rising.

From a longer-term perspective, the Fed believes that inflation is likely to stay low and stable due to secular forces like aging populations, technological advancements, and globalization. So that gives the Fed confidence it can deal with any upturn in inflation that might occur.

In contrast, there are some concerns among investors—and some very prominent investors—about inflation rising.

They see all the fiscal stimulus and this very easy monetary policy and conclude that that’s a recipe for inflation.

Now it remains to be seen how it plays out, but it has been a very long time since we’ve seen inflation over 3%—well over a decade. So I think the burden of proof right now is on the inflation worriers.

But keep in mind the Fed only controls the fed funds rate, the rate that banks pay each other for overnight loans. The Fed influences interest rates through its policies and its bond buying program, but the further a bond’s maturity gets from that overnight rate, the less influence the Fed has. So what we’re seeing is short-term rates staying near zero, reflecting the Fed’s desire stoke the economy, while long-term rates are rising because of these concerns about inflation and growth picking up.

MIKE: Well, Kathy, you mentioned bond yields have pushed up recently—so what’s causing that?

KATHY: Well, a couple of things. Economic growth is coming back much faster than anticipated, and that’s really the primary reason. A year ago, when the economy was in lockdown, we had no idea how long it would last, how bad it would be, but many economists were pessimistic. But it’s been a much quicker recovery than consensus, and when you add in the $1.9 trillion American Rescue Plan on top of the COVID relief passed just last year and the vaccine rollout going well—there are a lot of reasons to be optimistic about the economy.

Stronger growth typically warrants higher rates. Remember, 10-year yields were only 0.5% last summer—in the depths of the downturn. They’ve moved up to 1.75%, but that’s only about where they were when the COVID-19 crisis hit. And real interest rates are still negative—that means that they’re below the inflation rate. So with the strong recovery aided by a lot of government spending, it really does make sense for yields to move up.

MIKE: Well, these rising yields seem to have rattled the markets a bit. Is that because of the speed at which they rose? I mean, at the end of the day, who is being hurt by rising yields?

KATHY: Well it has been a fast run-up, and I think it caught a lot of people off-guard. The reason it has rattled other markets is that the Treasury market provides the benchmark for valuing other asset classes. So Treasuries are considered risk-free, and when you evaluate the price of other assets—whether it’s stocks or corporate bonds or even commodities—usually you look at the return you can get relative to that risk-free rate. So, when the risk-free rate rises, it starts to diminish the value of other assets. In other words, when the risk-free rate is zero, or half of 1%, just about any investment looks good by comparison. But as that risk-free rate rises, other investments that involve more risk may not look as good by comparison.

I think there may also be some concern among investors that the Fed may have to hike rates sooner than they are currently projecting and that could have a ripple effect through the global markets. Now, it may be premature to worry about that, but it is a concern that’s out there.

As for who’s being hurt by rising rates, well, borrowers of all sorts—whether it’s individuals looking for a mortgage or companies looking to borrow for expansion, higher interest rates make it more expensive, but it also does affect those riskier investments, since they tend to be the most sensitive to changes in any underlying cost of capital.

MIKE: Well, there’s no question that equities have felt some impact as a result. Are bonds taking some of the shine off equities? Should investors expect that to continue?

KATHY: Well, I do think bond market volatility is taking some of the shine off equities for a few reasons.

First, higher bond yields can make dividend-paying stocks less attractive on a relative basis. Risk-free 2% in Treasuries might look good compared to 2% dividend yield in stocks, since Treasuries are considered risk-free and tend to be a lot less volatile than stocks.

Also, higher bond yields could slow the economy down and be a headwind for corporate earnings. So far, this shouldn’t be a big concern. But if you think about, say, housing—rising rates cause mortgage rates to go higher, and that tends to curtail housing activity. So any sector of the market that’s especially interest rate sensitive might feel the impact.

So there’s likely to be more volatility in stocks going forward as the market assesses the pace and the magnitude of rising interest rates.

MIKE: Kathy, let’s shift gears a bit to another part of the markets that I think you pay a lot of attention to, and that’s municipal bonds. The huge stimulus bill that’s now working its way into the economy included $350 billion for state and local governments, hundreds of billions more for things like schools and public transit, as well as restaurants and small businesses. That’s bound to have a positive impact on municipal bonds. So is this where investors should be focused right now?

KATHY: Oh, yes—absolutely. We’ve called the American Rescue Plan a game-changer for the muni market.

The size of the funding is big, as you mentioned. It’s coming at a time when many states have bounced back faster than expected and more than expected, so it’s likely to provide a good boost to local economies.

Much of it’s focused on getting schools re-opened, and that’s likely to be a big help to local government and local employment. Over the past year, the education sector alone has lost about 1.3 million jobs. So even though teachers tend to be working virtually, a lot of other school employees are not—bus drivers, food service workers, crossing guards, some teaching jobs that are considered “non-essential” have all been cut. Getting over a million people back to work will be a huge improvement for communities—bringing in tax revenue, reducing the childcare burden, and increasing the use of transit, which is a positive for tax revenues as well.

And all that should boost tax revenues from a lot of different sources and help budgets at the state and local level.

MIKE: Well, the administration is expected to make a huge infrastructure spending package the centerpiece of its next big legislative push—although that is likely to take many months and be a very complicated process. There is generally bipartisan agreement on Capitol Hill about the importance of infrastructure—after all, every member of Congress has roads and bridges and tunnels in his or her district that need repair. But it’s far from clear whether Republicans and Democrats will be able to come together on a bill. But I’m guessing the muni markets probably don’t care whether this is a bipartisan bill or a Democrat-only package—any infrastructure bill is just another positive for the muni market, right?

KATHY: You’re right. It won’t matter who sponsors it. As long as there are funds allocated for local projects, it will be a positive for the muni market.

MIKE: Well, given everything that’s going on in the fixed income markets, does the traditional 60/40 split between equities and fixed income still work? Or should we be talking about a different ratio?

KATHY: Well, Mike, we’ve never thought 60/40 is right for everybody. The allocation you choose should be one that helps you meet your goals—whatever those are. Over long time periods, 60/40 has been a good mix for many people—and that’s why a lot of investors gravitate to it. It has delivered strong returns compared to more conservative allocations but without a lot of volatility compared to riskier allocations. So it’s a good place to start.

Even though bond yields are low and expected to move higher, they still do have a role to play in a portfolio. They’re good for capital preservation, for generating income, and, importantly, for diversification from stocks. The truth is few of us have the kind of money and staying power to handle a portfolio that’s 100% in stocks. So some allocation to fixed income makes sense in our view to reduce volatility and provide that ballast.

Bonds with higher credit ratings are usually the ones that provide that ballast and that safety in a portfolio.

MIKE: Well, Kathy, let’s wrap this together with the question you probably hear more than any other—what’s your recommendation for how investors should be allocated right now and going forward when it comes to the bonds in their portfolios? What strategies are you recommending these days?

KATHY: Well, when interest rates are rising, the most important thing to do is manage the duration of the portfolio. And duration is a measure of how sensitive a bond’s price is to a change in interest rates. Generally speaking, a longer-term bond will be much more sensitive to a change in rates than a short-term bond.

So we continue to think it makes sense to focus on lower duration or shorter maturity bonds to mitigate that risk of rising interest rates.

Bond ladders tend to work well in a market like this—where rates are rising and the yield curve is steep. That is, the difference between short- and long-term rates is large. That’s because they are designed in such a way that you have a bond maturing on a regular basis that can be re-invested in higher-yielding long-term bonds. Over time, you’ll end up generating more income that way. It also helps to take some of the guessing game out of the market, you know, trying to time when the right moment is to invest. It’s really similar to dollar cost averaging in stocks.

Now another issue to consider is inflation. If you’re concerned about inflation rising, you can consider shifting some of your Treasury holdings to TIPS—Treasury inflation-protected securities. These are bonds that are designed to keep pace with inflation.

MIKE: Kathy, you’re always so terrific at making sense of what I think is the most confusing part of the market. So thanks so much for taking the time to join me today.

KATHY: Thank you.

MIKE: That’s Kathy Jones, Schwab’s chief fixed income strategist. If you want to understand what’s going on at the Fed, what’s going on in the bond markets, just follow Kathy on Twitter—@KathyJones.

First up on my Why It Matters segment, last week the United States and China held their first high-level talks since President Biden took office—and they did not go very well. Secretary of State Anthony Blinken and National Security Advisor Jake Sullivan met with their Chinese counterparts for two days in Alaska, and tensions ran very high.

The U.S. delegation brought up a number of areas of concern, including China’s crackdown on Hong Kong, the rising tensions in Tibet and Taiwan, human rights abuses of the Uighyur people (the Muslim minority in Xinjiang province), and technology transfer disputes, just to name a few.

China’s representatives countered with a bitter statement that accused the U.S. delegation of adopting a “condescending” tone and arguing that the United States should get its own domestic affairs in order—specifically the racial tensions that have riled the country over the last nine months—before lecturing the rest of the world about how wonderful its democracy is. U.S. officials said the two days of talks resulted in no diplomatic breakthroughs, but an honest and open dialogue.

Why does it matter? Well, as I talked about on this podcast last month with Schwab’s Chief Global Investment Strategist Jeffrey Kleintop, the U.S.-China relationship is, to me, one of the most underrated challenges facing the new administration—and one that the markets are watching very carefully, given China’s global aspirations and the potential impact on emerging markets, currencies, and other investments. This first meeting between the new administration and senior Chinese leaders was a clear signal that the challenges are significant and the path to repairing the relationship will be an arduous one.

Finally, a conclusion to a story that we’ve been following for more than a month on this podcast: The IRS has officially delayed the tax-filing deadline to May 17. We had been expecting this for weeks, but IRS Commissioner Charles Rettig had been holding out for keeping Tax Day on the traditional April 15 date.

Last week, however, more than 100 members of the House of Representatives added their voices to the growing chorus of calls from Capitol Hill for a delay. Commissioner Rettig was scheduled to testify before a House committee on Thursday, March 18, and it was shaping up to be, well, let’s just say it would have been a very tough hearing for him. The night before his testimony, the IRS made the decision to officially delay the filing deadline for a little more than a month.

So the bottom line is that your 2020 tax return is not due until May 17. But there are still a lot of unanswered questions—the IRS has yet to release any guidance for tax code changes that were part of the new economic stimulus bill and is still working on some of the guidance for the previous stimulus bill that was passed back in December.

Another thing to be aware of—many states have already moved their tax-filing deadlines to line up with the new federal date. But not every state has done so yet. It’s possible that your state tax return will remain due in April, while your federal return will be due in May. And a few states have set due dates in June or even July. So be sure to check with your state and local tax authorities to be certain.

That’s all for this week’s episode of WashingtonWise Investor. I’ll be back in two weeks, so please take a moment now to follow the show in your listening app so you don’t miss an episode. And if you like what you’ve heard, leave us a rating or a review—that’s what helps new listeners discover the show.

For important disclosures, see the show notes or, where you can also find a transcript.

I’m Mike Townsend, and this has been WashingtonWise Investor. Wherever you are, stay safe, stay healthy, and keep investing wisely.

Important Disclosures

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk, including loss of principal.

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. High-yield bonds and lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax,

Treasury Inflation Protected Securities (TIPS) are inflation‐linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance and financial circumstances.

All corporate names are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Periodic investment plans (dollar-cost-averaging) do not assure a profit and do not protect against loss in declining markets.


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