MIKE TOWNSEND: It’s nearly August here in the nation’s capital. The heat and humidity are stifling―political tempers are getting short. The annual August recess, where Congress―and just about everyone else in Washington―gets out of town for a month, is just around the corner.
But, as often happens when the August recess looms, it feels like everything in Washington is falling apart. Negotiations on the bipartisan infrastructure bill are on the brink of collapse…or maybe they aren’t. But things certainly are not moving as quickly as hoped.
Democrats’ plans for an even more massive spending bill to boost the economy, to be passed without Republican support, have barely gotten off the ground.
And on Tuesday, the special Congressional committee to investigate the riots at the United States Capitol on January 6 held its first hearing amidst intense partisan bickering―all of which took a backseat to the harrowing testimony of four police officers who described in heartbreaking detail their experiences defending the Capitol that day, when things really did fall apart.
Welcome to WashingtonWise, 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 confusion of the nation’s capital and help investors figure out what’s really worth paying attention to.
While things in Washington seem very unsettled right now, that also feels true for investors. On its face, it has been a good year so far for investors, with the S&P 500 up about 17% since the beginning of the year. But I think it’s also been a confusing year for investors, with concerns about rising inflation, mixed signals from the economy, slow job growth, worries about the potential impact of the Delta variant, and other factors contributing to an uneasiness for a lot of investors. In just a few minutes, my Schwab colleague Kathy Jones will join me to try to piece together what the markets and the economy are trying to tell us.
But first, a quick update on two of the other issues making headlines right now.
First, as I record this, there still is not an infrastructure bill ready for consideration on Capitol Hill.
For the last five weeks, a bipartisan group of about 10 senators have been haggling over a package of about a trillion dollars in spending on so-called “hard infrastructure”–roads, bridges, rail, public transit, water projects, broadband expansion and more. And for weeks, the group has seemed oh-so-close to announcing a deal. But as of Tuesday afternoon, it still hadn’t happened.
Monday was the latest self-imposed deadline to be missed, and the beginning of the week was filled with news reports that the negotiations were on the brink of collapse. Republicans accused Democrats of making an offer that changed previously agreed-to elements. Democrats accused Republicans of “moving the goalposts” right before the end of the game.
Honestly, this is pretty standard stuff for the last stretch of contentious negotiations, so it’s very difficult to tell whether things are really falling apart or we’re just in the “it’s always darkest before the dawn” stage of talks. I’m in the camp that the infrastructure package will come together―perhaps even by the time you listen to this podcast. Infrastructure spending is popular with voters across the political spectrum, and it just seems that the bipartisan group in the Senate has come too far to walk away now.
But there’s no question that Democratic leaders are becoming more and more frustrated by the slow pace of these negotiations, and with the annual August recess scheduled to begin late next week, patience is growing thin. Once an infrastructure deal is announced, the Senate is expected to immediately begin debating that bill on the Senate floor, with votes beginning as soon as late this week. Senate Majority Leader Chuck Schumer of New York threatened earlier this week to keep the Senate in session through the weekend, if necessary, to make progress on the bill.
So, what’s the rush? Well, Schumer has said that he wants the Senate to pass both the bipartisan infrastructure bill and a budget resolution before the Senate breaks for the August recess. The budget resolution is the massive bill that would be the framework into which the Democrats’ $3.5 trillion spending package on climate change, health care, and social programs would be inserted. That package would also likely include tax increases on corporations and wealthy individuals to help offset the cost of all that new spending. But none of the details of that can be worked out until the budget resolution is passed, as that is what would trigger the Democrats’ ability to use the special set of rules known as “budget reconciliation” that would prohibit a Republican filibuster and allow Democrats to pass their economic plan with a simple majority. Of course, even if they pass the budget resolution, it’s far from certain that Democrats will be able to craft an economic bill that can win the support of all 50 Democratic senators. But no budget resolution means that the economic bill would be dead before it even started.
It’s a lot of moving pieces and the stakes for both parties are very high. At this point, it seems unlikely to me that the Senate will get both the infrastructure bill and the budget resolution done without delaying the August recess. But it’s often said that the most powerful political force in Washington is the risk of delaying Senators’ vacations―so maybe that will lead to a breakthrough.
Finally, an update on a key issue for investors that I focused on in the last episode―the debt ceiling.
The two-year suspension of the debt ceiling that was approved by Congress in 2019 ends this weekend and the debt ceiling is back as of Sunday morning. That means that the clock will start ticking toward the United States potentially defaulting on its debts for the first time in history if Congress does not pass a suspension or an increase in the cap on the total amount of debt that the country can accumulate.
Last week, Treasury Secretary Janet Yellen sent a letter to Congressional leaders spelling out the details. She said she would be starting so-called “extraordinary measures” this weekend to ensure that the United States does not default.
But she did not answer the questions that investors and Members of Congress really want to know: How long will those measures last? And what’s the deadline for Congress to act?
Yellen wrote that “Treasury is not able to currently provide a specific estimate of how long extraordinary measures would last,” but she warned lawmakers that “there are scenarios in which cash and extraordinary measures could be exhausted soon after Congress returns from recess in September.” Yellen is expected to provide more details to Congress in the coming weeks.
Meanwhile, the Congressional Budget Office, the non-partisan budget and economic analysis arm of Congress, released its own analysis last week, concluding that “Treasury would probably run out of cash…most likely in October or November.”
And also last week, Senate Minority Leader Mitch McConnell of Kentucky made it clear that Democrats should not be counting on Republicans for any help in addressing the debt ceiling. “I can’t imagine a single Republican voting to raise the debt ceiling after what we’ve been experiencing,” McConnell said. If McConnell and his fellow Senate Republicans follow through on that threat, it would mean Democrats would need to add the debt ceiling to that big economic package they’re developing. That’s a very risky strategy for the Democrats, especially given that it’s not clear the development of that bill will line up with the deadline for addressing the debt ceiling.
The bottom line is that there is still no clear and simple path for raising or suspending the debt ceiling―and that’s something investors should be tracking when Congress returns in September.
On my Deeper Dive this week, I want to explore the confusing signals being sent by the economy and the bond markets. I’m so happy that my colleague Kathy Jones, Schwab’s chief fixed income strategist is bringing her insights to this discussion.
MIKE: Kathy, thanks so much for talking to me today.
KATHY: It’s great to be here, Mike.
MIKE: Well Kathy, there is a lot of talk about what the bond market is telling us about the economy. But the bond market has been moving around a lot. So, let me begin by just asking you what’s happening and why is it attracting so much attention?
KATHY: Well, it’s been quite a ride for bond investors so far in 2021. It’s kind of a battle of the bulls versus the bears―or I think that’s just a reflection of the fast pace of change in the economic outlook. You know, in the first quarter, yields rose sharply because the pace of the economic recovery exceeded expectations and fiscal stimulus turned out to be much larger than expected. Ten-year Treasury yields―which are the benchmark for interest rates in the market―rose from about 90 basis points or 0.90% to as high as 1.74%. Then, in the second quarter, yields plunged down to as low as 1.15% despite surging inflation, the highest growth readings in decades, and indications that the Federal Reserve is considering reducing its bond purchases.
There are many potential reasons that have been posited for the volatility.
One reason is that investors were caught offsides this year and that’s exaggerated the moves as they scrambled to readjust positions. Many were too negative on the economy coming into the year, and then too optimistic in the second quarter. And, I think there is some truth to that. The rebound in the economy early in the year caught a lot of people by surprise. And few, including us, anticipated that the vaccine rollout would be so early and that fiscal stimulus would be so large. Then by the second quarter, the move up in yields had gone so far and so fast―it was probably unsustainable. And then we have the Delta variant emerging as a threat to the global recovery.
Another reason for the volatility is the idea that we’ve already seen “peak growth,” or the idea that there isn’t a lot of reason for yields to continue rising from here because growth has already reached its maximum level for the cycle. The big rise in GDP growth in the first half of the year isn’t likely to be repeated as the economy starts to go back to normal. And the emergence of the Delta variant has caused a lot of concern that growth will slow as consumers become more cautious and maybe some countries enact new restrictions on movement. And consequently, there’s just little impetus for yields to keep moving higher.
Then lastly, there’s the role of the Federal Reserve in all this. The Fed has been holding short-term interest rates near zero and buying bonds to keep on its balance sheet. These moves are supposed to help hold down interest rates to give the economy a boost. But in the second quarter the Fed started hinting that it would soon start to slow down the pace of its bond purchases because the economy is doing better. And that contributed to the drop in yields because it signals a step towards tighter policy.
So think of it this way. When the Fed buys bonds for its balance sheet, it is creating reserves in the banking system―and that translates into more money for banks to lend. The banks lend, consumers spend and businesses borrow to invest and that increases money in the economy. That’s how they “print money” or create money out of “thin air” That helps make borrowing cheap, but it also sends asset prices higher―everything from houses to stocks. That’s how quantitative easing boosts the economy. So when the opposite happens―when the Fed reduces the amount of bonds it’s buying―that tends to reduce the amount of money going into the economy and into financial assets. So consequently, when the Fed talks about tapering its bond purchases and moving up the timeline for rate hikes, as they did in the second quarter, it gets investors nervous. And I think stocks may have started to sell off based on that and that helped bond prices move up.
MIKE: Well, Kathy, if a drop in bond yields normally signals slower growth, but other signs right now are telling us to expect higher growth, what’s the disconnect?
KATHY: I think the disconnect is mostly about timing. Currently, the economic indicators are still strong, reflecting the impact of the economy re-opening, the strong fiscal stimulus that we’ve seen and, of course, the very easy monetary policy from the Fed. But that’s for right now. Looking down the road, it’s unrealistic to think that the year-over-year gains in consumer spending or business investment we’ve seen, will be so strong. Eventually the pent-up demand will get satisfied as supplies come on line and the economy will cool off. The peak in GDP growth was likely in the second quarter and over time, it’ll probably start to come down. I think that’s what the bond market is reflecting―the expectations for the next few years not just the current quarter. It wouldn’t surprise me if second-quarter GDP comes in at an 8% or 9% annualized pace, but after that we’re probably going to see GDP drop down in the 2.5% to 3% region in the second half of the year as the economy rebalances.
MIKE: Well it’s been really interesting to read in the media all the different commentary and speculation about what’s going on. Late last week, The New York Times wrote about how many Wall Street analysts are puzzled by what’s going on. They quoted a Goldman Sachs analyst who called the drop in bond yields a “conundrum” that ultimately is meaningless, and another analyst said that we might need to rethink the long-standing belief that the bond market tells us more about the economy than the stock market. So do you think everyone is just kind of overthinking this?
KATHY: I think there’s a lot of overthinking going on, but I also think the reality is that stocks and bonds are just two different markets driven by different forces, even though they are inter-related.
So, the treasury market tends focus on the outlook for Fed policy. It tends to have a higher correlation with GDP growth than the stock market, so that might be where the feeling comes in that the bond market is a better signal. And stock market values should reflect expectations for corporate earnings―since earnings are the source of returns to investors in the long run. So, in general, right now, earnings estimates remain pretty firm.
Bond yields, as I mentioned, reflect the expected path of the Fed funds rate―the rate that the Fed sets for short-term borrowing―plus a risk premium that reflects the chances that perhaps inflation will be stronger than expected. And right now, the market is suggesting that the Fed will take a slow approach to raising interest rates and that inflation isn’t a big long-term threat. So yields are low. I see it as a sign that the market expects slower growth, for it to revert to the mean and as a vote of confidence that the Fed will keep inflation in check despite current strong growth.
Now, there are long-term factors working in the bond market as well. The treasury market is a global market where about half the holders of U.S. bonds are foreign entities. Growth outside the U.S. has not been as robust as in the U.S. and yields in most other major countries are significantly lower―so they look good by comparison. Also, the demographic trends show aging populations in major countries―that tends to correlate with slower growth long-term. And then you add in high debt levels―which also tend to slow down growth―and it’s really hard to make a case for high growth or high inflation long-term.
MIKE: What about the 10-year Treasury yields―are they pricing in recession? Or maybe stagflation? That’s something we haven’t heard about since the 1970s, but if growth is slow and prices are rising, stagflation comes into the conversation. What’s your take on that concern?
KATHY: Well, I don’t think the market is pricing in recession. In the bond market, recessions are usually preceded by inverted yields curves―that means where short-term rates are above long-term rates. And that’s certainly not the case now.
Stagflation also seems unlikely. The economy is growing at a healthy clip and although it’s likely to slow down, there are few indicators pointing to stagnation. The rate of change is still positive on almost all indicators. As for the inflation side of things―I do think most of it is temporary. It hardly seems likely that used car prices will rise at a 10% year-over-year pace for very long. In fact, many of the things that surged in price―like autos, lumber, and other commodities―have already started to fall.
Now, you know, there are some comparisons to the 1970s since we’ve had a combination of fiscal expansion and easy Fed policy. But the big difference today is that these policies are being pursued by design to make up for a deficit in consumption and income caused by the drop in the economy due to the COVID-19 crisis. In the 1970s, it was more of an accident. We also had, in the 70s, a very different demographic profile. We had the emergence of the baby boom generation pushing into the workforce and driving up growth. In addition, wages were often indexed to inflation due to higher levels of unionization, and that in turn fueled the wage-price spiral. And finally, there were a series of policy mistakes―on both the fiscal and monetary side―that contributed to inflation getting out of control.
The U.S. dollar was allowed to “float” freely after Nixon made the decision to sever its ties to gold prices. After that happened it dropped pretty sharply, and that raised import prices contributing to higher inflation. In addition, there were the oil-price shocks from the oil embargoes and the policy response was inconsistent at best. The administration tried to impose wage and price controls for a while and it had an anti-inflation campaign urging consumers to cut back on spending. And mostly what that accomplished was it raised pent-up demand, but it also caused more layoffs. Finally, probably the big mistake was that the Fed Chairman at the time caved to political pressure from the White House and kept interest rates low in the face of rising inflation. It really wasn’t until President Carter appointed Paul Volcker, who allowed interest rates to skyrocket, that inflation came under control.
Today it’s just a different picture. The dollar is steady, the Fed has far more inflation-fighting credibility with the markets and is aware of the risks and the demographic profile of the U.S. that’s far different today than it was then. Keep in mind we have an aging population and that really tends to hold down the pace of economic growth.
MIKE: So given all that, what do you see as a realistic growth projection?
KATHY: Most likely, our growth rate will revert to the 2% region where it was before the COVID-19 crisis hit. That’s been our run rate for quite a while. One way to gauge what an economy’s growth rate is likely to be is to look at the combination, the sum of the growth rate in the labor force plus the productivity of labor. Right now, the labor force actually has been shrinking because of the COVID crisis. A lot of people were forced out of the labor force―but that’s most likely temporary. But based on demographics, the labor force is expected grow at about half of 1% per year. Now you add in our long-term average productivity of about 1.5% to 2.0% and you get a 2-2.5% GDP forecast longer term. Now it may be that some of the changes made by policymakers could lift that rate―such as changes to immigration policy and/or investments that could boost productivity. But overall―that’s, I think, a reasonable long-run outlook.
MIKE: Well, Kathy, what about the relationship between the stock market and the 10-year Treasury. What should investors be watching for?
KATHY: It seems to me investors shouldn’t be too preoccupied with this relationship. Interest rates do affect valuations for other financial assets―so higher interest rates are negative for stocks, all else being equal. But the difference between ten-year treasury yields at 1.5% and 2.0% really isn’t that big for the stock market. If Treasury yields were to move up to 3% or so―then they are competitive with some of the dividend-paying stocks, such as utilities. And highly indebted companies might also be at a disadvantage if interest rates rise.
On the other hand, steeply falling interest rates―if they are signaling growth concerns―can also have a negative impact by reducing the willingness of investors to take risks.
But for investors, generally speaking, I would watch short-term interest rates since that’s the rate that the Fed controls most closely. And watch the tapering of its QE program, its quantitative easing program, since that tends to slow the flow of credit to markets. Those may have a negative effect on P/E ratios, but as I mentioned, there are many other factors for investors to consider when it comes to the stock market, such as the earnings companies can generate, innovation, and really the overall health of the consumer.
MIKE: Kathy, you’ve mentioned the important role that the Fed plays in all this a few times. The Federal Reserve has, no question, added to this mix by sending signals that it may be at least thinking about tightening monetary policy, although it’s far from clear when that would start happening. So what is the Fed focused on?
KATHY: Well, I think the he Fed is focused on three things. First on employment, second on inflation, and third on financial stability.
And note that the Fed cares more about employment than unemployment. That is, they are focusing on all of the people who have fallen off the employment rolls. The measure we watch most closely is the labor-force participation rate for prime age workers, that’s people between 25 and 54. Up to 25 they may still be in school. After 54 is when you usually see those early retirements. So that ratio has rebounded quite a bit but it isn’t back to pre-pandemic levels, which I think is one of the Fed’s goals.
The unemployment rate doesn’t really capture all of those people. It has a lot of nuances to it, but the unemployment rate is not a full-employment measure that the Fed really likes to look at.
Fed’s also want an “inclusive” job recovery―so they are focusing on folks that don’t always have high participation rates unless the economy is really running at a strong growth rate. So they are looking at the employment rates for minorities, people with disabilities, older workers, you know all of the people who sometimes get left behind.
Now on inflation―the Fed is seeing the recent rise as mostly temporary due to supply disruptions. However, there’s clearly some disagreement about how high is too high among Fed members. If it looks like inflation and inflation expectations are going to keep moving higher- then the Fed may be concerned enough to tighten policy earlier than we anticipate. However, the inflation readings are indicating that the long-term trend, in terms of expectations, is that it will fall back towards that 2% level.
Then the third concern is financial stability. The Fed wants to make sure markets are stable enough that companies can get access to capital through the debt or equity markets and that individuals can get loans at reasonable rates. When financial conditions start to get tight or unstable it can slow down the economy.
MIKE: When he was testifying before Congress earlier this month, Fed Chair Jerome Powell kept calling the current increase in inflation “transitory”―it’s like the word of the month here in Washington. Do you think that’s the right way to think about it? I mean if you’re trying to buy a car or a house right now, it might not feel that way.
KATHY: Yeah, definitely seeing pockets of inflation right now, but I do think inflation is likely to revert to lower levels over time. The current steep increases are mostly related to pandemic-induced shortages. For example, used car prices, as I mentioned before, have been rising at a double-digit pace. That’s not likely to continue once inventories catch up.
However, the important thing is not whether its transitory―but where’s it land in the next couple of years. What’s the long-term outlook? I think we could make the case that it’ll settle at somewhat higher levels than the 1.5% that prevailed in the post-financial-crisis era. Fiscal policy this time around has focused more on the lower-income households with a higher tendency to spend what they earn. And that can translate into stronger consumer demand. Also, wages are rising at a pretty healthy clip. And if that continues, we could see stronger demand as well.
But ultimately, inflation is the result of supply/demand imbalances. And it’s also a global phenomenon. I can see somewhat higher inflation than in the past, but there really isn’t a strong case that it will exceed 3% for an extended time period.
MIKE: Well, Kathy, a question I know you get at every event that you do with investors is about interest rates. Interest rates seem like they are always on people’s minds, and while those low rates now, you know, are difficult for savers, they seem to bode well for borrowers. Some Fed officials have suggested that rates could go up next year instead of 2023 as we had heard for so long. So, do you think the Fed will back away from that? What will it take for rates to rise?
KATHY: Well, I think the Fed is watching closely, they’re doing what we’re doing―they’re watching the data and the Delta variant―to determine when the best time is to start to tighten policy. But they need to gauge the pace of the recovery globally. So, the most influential members of the Fed―Fed Chair Powell, the Vice-Chair Clarida and the head of the New York Fed Williams―seem to be inclined to be patient when it comes to moving interest rates higher. You know, the Fed has missed its 2% inflation target for the better part of the past 12 years, and that suggests to them that they should err on the side of easier policy, rather than being pre-emptive in tightening policy.
If the economy continues grow strongly above trend and the employment indicators are really strong, then the Fed might hike rates in late 2022. But first they have to taper their bond purchases―that probably will take about 7 to 8 months at a reasonable pace. So, the earliest we likely would see a rate hike would be late 2022. But it wouldn’t surprise me at all if the initial rate hike for the next cycle is in 2023.
MIKE: Well, Kathy, as usual, you’ve done a great job helping sort through a pretty unusual set of economic circumstances. Thanks so much for taking time to talk to me today.
KATHY: My pleasure, Mike.
MIKE: That’s Kathy Jones, Schwab’s chief fixed income strategist. Make sure you follow her on Twitter: @kathyjones.
Finally, on my Why It Matters section, I want to look ahead to September, which is shaping up to be quite a month in Washington, with Congress staring down a staggering pile-up of time-sensitive and politically complicated issues.
One key factor is that the government’s fiscal year ends on September 30. That means Congress has to pass the 12 appropriations bills that fund every government agency and every federal program by then, or risk a government shutdown on October 1st, when Fiscal Year 2022 begins. So how is Congress doing on those 12 appropriations bills? Well, the House was aiming to pass a package of seven of the 12 this week, but there are still five more to go. And the Senate has so far passed exactly zero. The chances of both chambers passing the exact same versions of each of the 12 appropriations bills between now and the end of September is also pretty much zero.
That means Congress will have to pass what’s called a “continuing resolution,” it’s a temporary measure that keeps the federal government funded and operating for whatever amount of time lawmakers choose―it can be a few days or few months. Doing so is common―it happens most every fall―but it’s not without controversy. And failing to pass a continuing resolution would mean a government shutdown.
At the same time, both the still-in-limbo bipartisan infrastructure bill and the yet-to-be-even-drafted economic bill and its potential tax increases will also be looming in September. And, as we have been discussing over the last two episodes, Congress will need to address the debt ceiling in the September/October timeframe. All told, the bills I just mentioned could carry a price tag of more than $6 trillion
Just to make things even more complicated, the House is only scheduled to be in session for the last two weeks of September, with the Senate in session for only a few more days than that. Right now, it’s hard for me to see how all this gets done in that short window.
Why does it matter? While I often remind investors that the markets can be relatively indifferent to what goes on in Washington, I think September will be one of those times when the markets will be paying close attention to what’s happening on Capitol Hill. The potential for a government shutdown, the need to raise the debt ceiling, a long-awaited infrastructure package, and the potential for tax increases on investors and trillions in new spending―there’s no question the markets will be focused on the outcome of these looming political battles. So stay tuned, I’ll be back in September with updates and insights about it all.
That’s all for this week’s episode of WashingtonWise. We’re going to take a break in August, so I’ll be back with a new show on September 16. 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 really helps new listeners discover the show.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I’m Mike Townsend, and this has been WashingtonWise. Wherever you are, stay safe, stay healthy, and keep investing wisely.