#1011 - Will Inflation Derail Bonds? | with Kathy Jones

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1:04is inflation going to derail bonds hi everyone welcome to the real vision daily briefing i'm maggie lake with me today is kathy jones chief fixed income strategist with charles schwab hi kathy how are you uh fine maggie thanks for having me on the show yeah thanks for coming back it's great to have you so um such an interesting week we had we saw stocks were kind of flat to mix Treasury yields slightly lower in today's session, but you just get the feeling that everyone's just marking time ahead of what's going to be some really key inflation data. And we've got several reports coming out this week.

1:36What are you expecting to hear on prices? Yeah, I think the consensus estimate for CPI is up three-tenths of a percent. That seems like a reasonable enough estimate. You know, we are now in a place where people want to take it out to two or three decimal points to try and evaluate the underlying trend, which is getting a little ridiculous. But I think three-tenths is consensus. That seems like a reasonable enough estimate. I don't see it as quite as life and death as a lot of people do. We have a lot of inflation data to sort through. But yeah, I think the market's poised, I think, for the possibility of a bad number.

2:19So everybody's kind of holding their breath. Yeah, that's really what it is, isn't it? It's not that, you know, we always say you need a trend and you need multiple readings, but there seems to have been a shift in sentiment that the best news on inflation, that, you know, lower trajectory that was helping bake in those Fed easings, maybe that's at risk. And maybe not only are we not seeing a decline anymore, but now we're seeing a reinflation or higher inflation, and that's throwing this rate outlook up in the air. That seems to be the concern. Do you share that concern? Well, I think it is a concern that we've seen a couple of months of more, you know, a little bit upward trend months a month, a little more sideways action, if you will.

3:04And we do want to see it continue to come down. We do want to see the monthly readings be, you know, 0.2 or so to continue the overall trend down. But that being said, I'm not overly concerned. I think the market's making a big deal out of a lot of short-term information here. And when you do look at some of the leading indicators on inflation, especially the core PCE, which the Fed is targeting, you see things that are signaling lower inflation, such as the ISM services price index and services where the inflation numbers have been sticky. You know, that's really fallen now. So that may be an indication that supply and demand in the service sector is coming back into balance.

3:51Also, the quits rate in the JOLTS report, that typically will give you kind of a good leading indicator of where we're going wage-wise and inflation-wise. So the things that correlate with future inflation are still in pretty good shape. But we do have to get through this near term uncertainty as to whether that trend will continue or whether we're just going to move sideways here a little too high for the Fed's comfort level. Yeah. And it matters, I think, to people, especially now, because we're getting into that zone where even with the recalculation, people were kind of targeting that late spring, early summer for those rate cuts.

4:33And so if you don't start to get evidence of it, part of the equation, too, is that the economy seems like it's been we keep hearing the economy is resilient. It seems like it's been more than that, more than people expected. Can we grow the economy? Can the economy run hotter without the risk of inflation coming back and causing a problem for the Fed? What do you think the discussion is with the FOMC right now? Yeah, I think that's the big debate. That and, you know, where is the neutral rate? Should the neutral rate be higher? Because the economy has the ability to grow at a faster rate, and therefore we don't need to be looking at slower growth ahead in order to get inflation back to 2%.

5:16So I think the debate really is, have we reached a point where we can't do any more good on inflation because the economy is running too hot, it's a demand side too strong, or are we getting enough in the way of supply response that we can continue to see growth without generating a lot more inflation? I'm more on the optimistic side about it. I think that we do have a lot of growth potential. We've seen a pickup in productivity. That's notoriously difficult to measure, and especially in the short run. But it does seem that we've demonstrated that, yeah, you can have lower unemployment for a long period of time.

5:54And as long as you're getting more people into the workforce, you're not generally overwhelming the economy on the demand side. So I'm more optimistic than many that we can get there without having to kind of crush demand. But I'm not sure that the Fed is there or that the market is 100 % there. So, you know, that's why they're data dependent now. We're just going to have to wait and see how it plays out. Yeah, they love to say that. And it did seem for a bit that they were really committed to staying on that easing path because even in the face of some hot data, they were talking about it. But so many have come out and seem like verbally, they're sort of setting the stage for, Well, you know, we've got to see, maybe not.

6:38What does that mean for the 10-year? Because we did see the 10-year yield move back up. And of course, everyone's watching rates because of the impact it has, because we'd seen so much bond volatility in treasuries over the course of the last year as everybody tries to anticipate that lower rate. And then they've gotten their head handed to them. So we've seen rates move up, but they're still hanging down around that 4.3, 4.4 level. We haven't seen that fear bring them all the way back up to 5%. So I'm just wondering how you think this trajectory looks as we move through these critical meetings that are coming up.

7:16Because it's got to affect everything else in the bond world for you, I would think. Oh, yeah, absolutely. So, you know, it is important what the Fed does. So when we break down what drives treasury yields, particularly 10-year yields, it is Fed policy, it is inflation, and it is economic growth. And a lot of the rest of it is noise, right? You know, you get a lot of people throwing out ideas about what's driving the market. But, you know, Fed policy, inflation, economic growth. And where we have such uncertainty is Fed policy now. So yeah, we came into the year, it was like, okay, we're gonna cut rates three times in the dot plot.

7:56And all of a sudden now we're hearing from various people at the Fed, like, well, maybe it'll be one, maybe it'll be none. I don't know, we have to wait and see. And that throws the 10 year off because to some extent, long-term rates are a function of short-term rates, that discounting and inflation expectations and economic growth. So when you take that one factor Fed policy and you throw it up in the air and say, yeah, maybe this, maybe that, we don't really know, then you get a lot of volatility in the market. And I think what we're doing now is reacting to every single data point as if it's decisive, right?

8:34That it's not an accumulation of data, but it's like, okay, CPI is this, therefore, you know, no rate cuts this year. Or CPI is that, okay, let's pencil in five rate cuts. So we're just all over the place. We came into the year expecting three rate cuts starting in the second half of the year. We're sticking with that forecast just because we don't have any reason not to stick with that forecast yet. Obviously, it could be two, I think, would be a plausible outcome as well. We're listening to people like Rafael Bostic from the Atlanta Fed, who was in favor of cuts and now is like, well, maybe one.

9:13But you can tell that this is just everybody trying to game it at every data point. And I think that that gives us a lot more volatility, particularly at the long end, which is a big function of inflation expectations. Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo.

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10:40Yeah, it's so true. We've been sort of describing it as everyone running from one side of the ship to the other. And it has created this volatility in bonds, especially treasury bonds. I mean, you're not traditionally used to seeing some of the swings. I mean, we're certainly not at the point where last year. But you brought up a couple of points I want to get your thoughts thought about because the Fed is so central. And one of them, Raoul Powell and Julian Brigden sat down for a macro insider conversation, and they discussed the idea that central banks may not have a lot of options. I mean, this is something we hear that kind of backed into a corner.

11:19Let's listen to that clip, and then we'll talk on the other side. How I think it through is, let's say Jim is right. I don't have a beyond the bond market right now because I think there's this This whole issue of issuance and deficits is something we hadn't really faced in the bond market for a long time. Let's say he's right. What happens? My answer is they will have to do something because they can't refinance the debts of 5.5%. So I think markets know this. So let's say he's right. That would be a confirming factor why gold is screaming higher.

12:03the markets are kind of telling us that we've got a problem somewhere and whether it ends up having to be yield curve control or whether it has to be whatever mechanism they will use they will find a mechanism they'll have no choice because as Julian said the big boss can't go bust I mean I think you get pain before you get there mate but I totally agree with the long term outcome they have to I don't know if you'll get the pain because the markets see through it But that's my thesis here is like gold seeing through it. Yeah, and that's why I'm not waiting for the pain to buy it. With real rates, gold should be falling, right?

12:39With the dollar, gold should be falling. It's breaking out, right? That's a huge macro signal. Correct. I agree. It's based on something. It was a fantastic conversation because those two haven't sat down in a few weeks together. And you can get the entire conversation on our website. If you are not a member, you can hit the link that Brian put in the chat and join. So, Kathy, this comes up a lot when people are also trying to not only gain the inflation data, but look at this bigger issue of debt. And one of our members in the chat just said, Fed policy inflation growth. What about Yellen in the background pushing liquidity?

13:18LOL. well, but is this idea that there is this debt issue, they can't afford the interest rate payments, and sort of the market is sniffing that out. And that's creating some of that tension as well as people try to figure out when that easing is. How do you think about that issue of debt, that bigger issue, as you're trying to look at least through the next few months here? Yeah, I think it's really difficult to tie short-term movements in treasury yields to supply. So I have spent many, many hours of computer time, a lot of brain cells, trying to find the actual statistical correlation between supply, between issuance and yields.

14:06And frankly, it's been unsuccessful effort. And I say this going back decades to when I was on a trading desk. And I sort of always had this thought that was expressed to me by traders like, oh, every time there's an auction, you know, yields have to back up a little bit to absorb the supply. And then we rally. And I thought, well, if that were true, that's like a guaranteed trade, right? Like, I'm going to do this trade. And then, of course, I ran the numbers and it turns out that you had a 50-50 shot of being right about that. So I don't want to overemphasize supply in the short run. I think in the long run, obviously, our buildup of that is a big concern.

14:47Right now, the current rate on that is around a little less than 3%. So we're not financing it all at 5%, 5.5%, nor will we have to going forward because the Treasury has a lot of options. So I'm probably less concerned about that being a 2024 issue as it is a longer term issue. You know, we have the privilege, the exorbitant privilege of having the world's reserve currency, which does give us a sort of a guaranteed audience, a level of demand for treasuries. And there's nobody kind of challenging that right now. So in an ideal world, we'd outgrow our debt, right? It would grow faster than the debt grows and would come down relative to GDP.

15:36That clearly isn't something Congress is embracing right now with the budget. So I do worry about it. Longer term, how much more do yields have to go up to attract foreign capital, to attract domestic capital? But right now, we don't see evidence that that's a real problem. Foreign buying continues to be pretty strong. Domestic demand at these yields has been very strong. when households have been buying a lot of treasuries. You put money into a money market fund and you're buying treasuries. So right now, these levels demonstrably are enough to attract capital, but obviously as we go longer term, it's a problem.

16:15As for gold, over the years, typically you do see an inverse correlation between real interest rates and gold prices. So this is a little unusual seeing this divergence. I don't know whether it's though concern about the buildup in debt or just expectations that those interest rates are coming down. You know, we've had so much talk about easing policy, not just in the U.S., but the ECB, et cetera. So it may be the market is building in that expectation. And then we've had strong demand out of Asia, maybe some central banks like the People's Bank of China trying to diversify their holdings a little bit.

16:54But again, hate to read too much into this move in gold, translate it directly back to the treasury market. I think there's a lot of dots to be filled in there. Yeah. And it is the tough thing about this macro environment because there are so many cross currents that it's very hard to look at that. It reminds me of something one of our frequent guests says, like, I have to trade the market in front of me, right? So there's a longer term conversation about debt and what that means. But right now you have to trade what's in front of you. So we have another question. I think we've already sort of answered this, but I just want to be clear about it.

17:34Ralph asking, are you in the higher for longer or some other camp? You're expecting easing. So it sounds like you do expect rates, the Fed rate fund rate to go down and therefore treasury yields as well. Are you looking at a range? Do you think that, you know, it sounds like you've maybe thinking about pairing back how many rate cuts you think they're going to do. So what camp do you think you fall in here? Yeah, I think higher for longer implies, you know, years of high interest rates. And I don't expect that. I do expect some Fed easing later this year into next year. But I don't think we're going back as low as the Fed's projections, you know, that 2.5 % Fed funds.

18:19Maybe during a recession we'll get there. But as a resting place, three, three and a half seems to be more realistic, assuming the dynamics in the economy continue, which is a big assumption. But we have seen a big pickup in labor force participation that should drive productivity, it should drive economic growth, more people working, more people earning a check means more spending, more demand in the economy. and that would tend to indicate, yeah, we should have somewhat higher rates. Two and a half was probably a post-financial crisis kind of environment. We're in a different environment now.

18:59But I don't think five and a half is the resting place. I think five and a half, particularly with 300 basis points of real rates, is pretty high. And particularly when you look around the world and you look at still sluggish growth in China, weak growth and falling inflation in Europe, Japan kind of fighting its way out of deflation. I'm not really sure we're going to make the argument that there's such a robust global economy that we need to have 5.5 % rates or 3 % real rates in the U.S. for years to come. Yeah, I think that's such an important clarification because when we were in that super low interest rate environment, everybody was pointing out that and worried about us being in a sort of deflationary spiral we could never get out of, and that they were really too low, or the fact that they were so low is indicating something anemic and not great about the economy.

19:55So the fact that we're higher, maybe not the worst thing, but where that settles is causing so much angst right now. I think when you're talking globally, this is another point that I wanted to bring up that's come up today. You had Mohamed Alarians talking about, are now the global central banks on different at a different pace from each other? Are we going to see, you know, it's really been coordinated for a long time in, you know, working in lockstep, whether intentionally or not. But do you think now we're going to see a differentiation between who goes when? Could the U.S. hold rates or be more reluctant to cut rates?

20:39And we can see the ECB going beforehand or other central banks. We've already seen a couple move. Are we going to see a big divergence? And what does that mean? Yeah, you know, we are used to this sort of synchronized activity with the Fed and the lead. You know, the Fed being kind of the central bank to the world, right? But what the Fed does, everybody else does eventually. And this time does seem different. Just like so many things about the cycle are different, this time does seem different. So, you know, you've got the big three. You've got the U.S. holding off maybe on rate cuts. You've got the ECB probably going in June from all the indications that that's a likelihood.

21:20And then Japan raising rates. So we've got a lot of divergence already. As you mentioned, a couple of central banks have already cut rates, emerging markets, central banks, seen some rate cuts there from very lofty levels. So this is going to be the first uncoordinated or at least not synchronized cycle in a long time. And I think how that plays out is in the foreign exchange market. I think you see a lot of the volatility in rate expectations playing out in the foreign exchange market. We've seen the euro come down. We've certainly seen the Japanese yen come down like crazy, despite the hike in rates, because it's expected to be slow.

22:04So I think the first tip-off is in the FX market, and then it translates maybe more broadly into the fixed income markets. But yeah, it means, again, probably more volatility, more people trying to figure out who's going when, where, and how fast. So, you know, amongst the major central banks, ex-Japan, the direction of travel is likely to be lower in rates. The speed is going to vary and the final destination is completely up in the air. So there's a lot for the market to try to deal with. And this may be a more volatile cycle than we've seen for a long time. We're going to take another quick break to hear a word from our partners.

22:49We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:56Yeah, which, as we know, when there's volatility, there's also opportunity. So let's talk a little bit about that, because it was important to spend that time, I think, on what's happening with treasuries because it matters so much. I mean, it's been such a source of confusion. But where do you see opportunity in the bond market? Well, we've liked investment-grade corporate bonds. And now the spread's very, very tight right now. And we're seeing some differentiation amongst the various ratings in terms of performance of the bonds. But in an environment that we seem to be in where corporate profits, I mean, they hit an all-time high last quarter.

23:37They're still growing. The economy's still doing well. They're tolerating high interest rates because they've probably turned out their debt or they've got just enough demand that they can handle the interest payments. So investment-grade corporate bonds still deliver 5 % plus. And so for investors, we have a lot of people sitting in short-term cash, money market funds, saying, well, I'm getting 5 % plus. Why should I go into a treasury with longer duration for a lower yield? That doesn't make sense to me, except for reinvestment risk. As we get rate cuts down the road, there'll be some reinvestment risk.

24:14But I can understand the reluctance. If you want to lock in some of those cash flows, we think investment grade corporate bonds at 5 % plus, five to seven years, it's a way to extend duration without giving up a lot of yield. And that, for us, that's an opportunity. high yield you know you can clip the coupon probably and do okay again valuation wise spreads are very very tight if there's a glitch something goes wrong you know those spreads tend to really widen really fast so yeah are you surprised they've stayed as tight as they have because so many times we've had people ask about that even when it looks like there's stress in the system, just surprised that high yields hung in so well?

24:58Yeah, it has surprised us. We've been more cautious than probably we needed to be. And I think when I look at it, what we see is that, yeah, some of the companies were able to term out their debt, but I think a lot of it, this market, there's just tremendous demand for yield still. After being starved for yield for a decade, People look at high yield, they say, you know, six, seven, up to 8%. I can ride out a lot of volatility as long as I don't get a big spike in defaults and the economy doing well. You know, I'm not worried, too worried about defaults. So we're seeing that demand every time spreads start to widen, that demand really comes in.

25:38We also had a lot of participation in the market on the private credit side. So it's taken some of the supply away that normally would probably have ended up in the high yield market. So I think that that's been a component as well. It has held in, but still a little bit cautious because, you know, when the spread moves, it spikes. And, you know, you've got to be prepared for that. That's so interesting. The private side has been active in buying. So that's a buyer that's been in the market that maybe wasn't to the extent before. Is that what you're thinking? And do they feel like hands that are hold on to that?

26:13Or does that also, do they also sell when things get, you know, does it give a little bit more stability to the market, given that it's coming from that area? Well, we won't know until the cycle plays out entirely. I think a lot of small companies have gotten financing on the private credit side. And the deal you make when you invest in private credit is that you're supposed to be committed for a long period of time to get those higher rates of return, and they can put up gates, so you give up liquidity, right? So the question becomes if we hit a real serious problem in the market and people can't get their money out, do they sell something else to get liquidity, right?