And this is On Investing, an original podcast from Charles Schwab. Every week we analyze what's happening in the markets and discuss how it might affect your investments.
Well, hi, Collin. So your world has been interesting lately. I feel like there's been relative calm in my neck of the woods, in the equity market, although some volatility, but your world is in the news, and it's a big world because it's not just the move up in bond yields that has occurred in the United States. It's a global phenomenon. So let me just toss to you a really broad question: What's going on? And what's to blame for the move up in yields? And then maybe I'll weigh in on implications for the equity market.
Yeah, Liz Ann, it's very exciting. I sort of have a gauge of 'Is the bond market making headlines or not?' And it's if my dad texts me. And so he did text me this morning. So it's, you know, Wednesday, August 19th, and said 'What's going on with bond yields?' So if he's asking, I know a lot of people are asking, and there's a lot of drivers. You kind of alluded to them before. What happened, though? So we saw long-term yields rise pretty sharply recently. The 30-year Treasury yield touched 5.3% earlier this week, highest since June of 2007. The 10-year Treasury yield rose above 4.7% earlier this week. I think there's a lot of drivers of what's been moving them higher. A big driver is really the Fed's hawkish bias. And if we have the Fed no longer likely to cut rates like what we and many expected earlier this year, if they're going to hold steady or potentially hike, that supports the case for higher long-term yields. There's a number of ways we can track what's driving Treasury yields. There's models we get from the Federal Reserve. And there's two things that we can point to. One is really just the expected short-term rate. If the Fed's going to hold or hike, that results in kind of a higher bias across the yield curve, but also the term premium. So the term premium, you can call it a risk premium. It can be described as the premium you earn for the Fed to not necessarily deliver what markets are expecting over a certain time frame, or if expectations don't meet or if the Fed doesn't deliver what markets are expecting. I just think it's an uncertainty premium, though. And I think that's a key factor right now. If you asked me two weeks ago what was the driver, it was mostly expected short-term rate, but over the past two weeks or so, it has been that term premium, which is more uncertainty, inflation uncertainty, fiscal concerns, things like that.
The way I phrased that just now, inflation uncertainty is important because it's not high inflation expectations. I want to make that pretty clear, because we can get inflation expectations from the Treasury market and the Treasury Inflation Protected Securities market, the TIPS market. Inflation expectations are very well behaved. They ticked up a little bit over the past few weeks but are still down from where they were in earlier this March and kind of at the lower end of their recent two- or three-year range. So it's really not an inflation expectation story right now. I do think it's more about term premium, uncertainty, fiscal concerns. We could point to, although I think it's a minor factor, the large supply of corporate bond issuance we've seen. There's this idea that 'Is corporate bond issuance crowding out Treasury supply?' I don't think that's necessarily the case, but we're just seeing a lot of issuance right now, whether it's corporate bonds, the Treasury, equity, IPOs, initial public offerings, a lot of supply coming to the market, which means you need to find buyers. But I think what's important when we look at what's happening with our Treasury yields, and you mentioned this at the start, Liz Ann, it's a global phenomenon. Most global yields are up year to date. If we look at 10-year Treasury yields, through Tuesday, August 18th, the 10-year Treasury yield was up about 54 basis points. Japan was up even more, about 83 basis points. United Kingdom 10-year bond up 60 basis points. France, 55 basis points. So it's not just a U.S. story. It's a global story. I think that's important because there's also this idea of 'Is this a Fed credibility issue? Is the Fed holding, and markets are getting concerned that it can result in higher inflation down the road?' I'd say the global aspect of this tells me that it's not necessarily a Fed credibility issue. And it's a number of things. I think if time goes on, and the Fed, let's say, doesn't hike, and the data suggests they should, then we'd have a credibility issue. We're not there just yet. But it's making a lot of headlines right now when you see a 30-year yield above 5% or the 10-year approaching 5%, it's obviously concerning for our government finances because we need to fund ourselves through Treasury issuance. So we have a lot more debt outstanding now, which means higher yields and higher borrowing costs on a much larger base of debt outstanding. And I think that's part of the puzzle right there. And when you add all that together, it supports our case that we're in this higher-for-longer period right now. But higher-for-longer in our view doesn't mean significantly higher. We're not necessarily worried that long-term yields are going to jump much higher, like, let's say, 6% plus on the 30-year or well above 5% on the 10-year Treasury yield. But we think yields might have some sort of a floor here, given all those concerns we're seeing, and given that it's a global phenomenon. So that's kind of my view. So what's front and center for you? But I guess is there a tie-in, are higher yields, are they impacting the stock market at all?
Yeah, so I think, you know, the feeder of what happens in the bond market to the stock market, as it relates specifically to Treasury yields moving higher, there's several factors that define whether it's — if it's an orderly move on the bond yield side, it tends to be a little bit more orderly within the equity market. Anything that is disorderly or really sharp from a time duration standpoint tends to upset the equity market a bit more. We certainly saw that about 15 months ago in the aftermath of Liberation Day. But you can also look under the surface of the indexes to understand what have already been some of these implications on the equity market because you've got higher real yields obviously raise the discount rate applied to forward-looking earnings. And that mechanically compresses multiples, you know, valuation levels. And it tends to hit what we — and it's a bond market term, but we can apply it to equities too — it hits long-duration growth stocks the hardest. So areas like tech and communications services because their cash flows are most backloaded. So that's a feeder into where you see an impact on the market. You also have the interest sensitive segments of the market like real estate, like utilities where there's now more competition for those types of stocks, higher-yielding stocks, from the relative safety of Treasuries. And that's why you're seeing the weakest performance and the weakest breadth over the past month or so in areas like the real estate sector and the utilities sector.
And I think ultimately, though, the critical question as we look ahead is whether higher yields reflect stronger nominal growth. That tends to be a pretty beneficial time for equities, or maybe a structural repricing of, as you mentioned, Collin, the term premium and inflation risk, and that tends to be more damaging. And it's part and parcel with what we have been writing about and talking about for quite a few years now. And in fact, and maybe we'll put it in the show notes a link, a report that Kevin and I wrote last month about, and it was an update because we've written about it before about having exited the so-called 'Great Moderation Era' which was the era from the late '90s up until the 2022 inflation spike. And there were lots of forces in that era, not least being globalization, the energy boom, but it was an environment of very little inflation volatility, generally a disinflationary trend, which meant fairly benign interest-rate backdrop, and in turn less uncertainty with regard to Fed policy. But the 30-plus years prior to that, the mid-sixties to the late '90s, was distinctly different. And that was an era of more inflation volatility, more uncertainty with regard to monetary policy, demand shocks, supply shocks, some of which we're seeing right now. The most important distinction between those two eras that ties your world, the bond market, with my world, the equity market, is the relationship between bond yields and stock prices. So in the Great Moderation era, for the most part, save for a brief period in 2008, bond yields and stock prices moved in the same direction because bond yields were keying more off the growth side of the equation, less off the inflation side of the equation. So stronger growth without the attendant concern or risk of inflation, that's sort of nirvana for the equity market. Well, you go back to what we've been calling the 'Temperamental Era' from the mid-'60s to the late '90s, almost that entire 30-plus year period of time, bond yields and stock prices moved in the opposite direction because bond yields were keying more off of what was happening with inflation. So higher yields because of higher inflation, not necessarily because of higher growth, negative environment for equities, and vice versa. So I think this is an environment not only to understand the short-term gyrations that are happening in the bond market and the implications for the equity market, but thinking in more structural terms. So I'd encourage anybody that didn't take a look at that piece to check it out because it really frames with a length that we don't have time for on our lovely little podcast here.
Yeah, it's a great point. And it does tie into the bond market outlook in terms of Treasury yields and Fed policy, where, if you get supply shocks, you maybe you can look through them if it is a one-time supply shock, but we're getting a lot more supply shocks these days. And I brought this up on our interview last week. We had a former Fed official, Dr. Richard Clarida, and I asked him about that. 'How do you view monetary policy through the lens of now we're seeing a lot more supply shocks?' So it's harder to kind of figure out what is a one-time thing versus is this something we should expect going forward. And that's a great segue to you, Liz Ann, because this week, you're interviewing someone else who has a lot of interesting thoughts on this topic, also.
Yeah, so like our guest last week that you had the great fortune of interviewing, the wonderful Rich Clarida. Now this week's guest is also a former long-standing member of the Federal Reserve's Federal Open Market Committee, or FOMC, and it's Jim Bullard. So Jim served as CEO and president of the Federal Reserve Bank of St. Louis for 15 years. And before becoming president in 2008, Bullard served in various roles at the Federal Reserve Bank of St. Louis, starting in 1990 as an economist in the research division and later serving as vice president and deputy director of research for monetary analysis. In July of 2023, he was chosen as the inaugural dean of the reimagined Daniel School of Business at Purdue University. During his time as an academic economist and financial policy scholar, Bullard's research has appeared in premier journals, including the American Economic Review, the Journal of Monetary Economics, Macroeconomic Dynamics, and the Journal of Money, Credit, and Banking. The majority of Jim's research is some form of macroeconomic analysis, tends to focus on monetary policy, inflation, deflation, and macroeconomic stability. Bullard received his doctorate in economics from Indiana University, and he holds bachelor of science degrees in economics and in quantitative methods and information systems from St. Cloud State University. So Jim, thanks so much for joining us. Much appreciated.
Glad to be here. Thanks for having me.
Sure. So let's start on maybe the obvious subject, core inflation, which has been pretty stubbornly above target for a number of years. So maybe start with where the line is between patiently restrictive policy and the risk of falling behind the curve again.
Well, I think the committee is very much at risk of falling behind the curve because they've been tolerating 3% core PCE inflation for several years. I checked, and at the end of 2023, it was 3%. At the end of 2024, 3% or higher, at the end of 2025, 3% again, and now they're projecting for 2026 that core PCE inflation will be probably 3.2%, which is actually the highest of all those. So really, no progress over four years. It looks like they're accepting 3% as the inflation target. Chairman Warsh has said forcefully that he does not want to do that, and he wants to push inflation down to 2%. Now exactly how he's going to do that, I don't know, but this is really the issue. This is a bigger issue, I think, than whether the last inflation report came in hot or cold. I think the main issue is, you know, what is the strategy for the committee to get inflation down to 2%? Now you can say, you know, we think some of these factors are temporary, and we think that policy is restrictive, and that will push inflation back down to 2% gradually. But that was the Powell Fed's policy. So whether Chairman Warsh wants to adopt that policy or not, I think, is one of the key questions going forward.
So Jim, what data do you think is most important? And do you think market watchers and Fed watchers are aligned in the thinking around what data matters most relative to right now what the Fed is thinking about what data matters most?
No, I think they're aligned. Chairman Warsh doesn't like to talk about the most recent data and doesn't like to give forward guidance, but I think the parameters of the discussion are well established. Certainly labor market data is important. Certainly growth and productivity is important. The AI boom is feeding into that, some international factors as well. And then of course the inflation data itself. So I think that constellation is unchanging, and I think that'll be the same going forward.
Let me pull on the AI thread a little bit since you mentioned it. There's the ongoing debate about whether AI will ultimately boost productivity enough to improve the inflation growth tradeoff. So how are you thinking about it, and what would you need to see before you think that we will collectively treat AI as a truly meaningful macro force, to a greater degree than what's in place right now, which is a little bit more of a market force.
Yeah, I think the AI boom is very much in progress. There have been a lot of analogies drawn to the internet boom, and I think that's probably a good place to draw some lessons. The internet boom eventually permeated the entire economy and did change the way we work, the way we play, the way we think, everything, so it was very much a general-purpose technology that mattered. But nevertheless, there are booms and busts within that. Some companies rise, other companies fall, and even the whole market fell in 2000, 2001. And so I think something similar will happen with AI. I think some of the conceptions that are around today about how AI is going to permeate the economy are probably not right, others are spot on, and what the market will do is sort out winners and losers as we go forward. And we're hearing all kinds of reports every day about how that contest is moving forward. So it's exciting and I do think it's eventually going to be a general-purpose technology that will permeate the whole economy, be very important. But that doesn't mean every single thing that's going on is going to be the thing that is the important thing going forward.
Have you done much work on or do you worry about the circularity of financing and how many more debt deals are done these days to finance the build-out? Is that something that you've put a lot of thought into?
I've thought about it. I don't have any independent research on it or anything, but I do think that this is part of the culture and style of Silicon Valley is to have circular deals. Sometimes it works; a lot of times it doesn't. So I think Wall Street is right to call that out and question that. And generally speaking, I would say the West Coast is still very hot on AI. And I think one thing is you have to keep in mind that you've got these IPOs coming up, there's a lot of money to be made, so there's a lot of hype coming out. And I think Wall Street's been right and global financial markets have been right to call some of that into question and start to ask tough questions about where's the revenue coming from.
Speaking of markets, these days markets are so fast moving. There's so much more fast money in the market, whether it's on the institutional side, the systematic funds and hedge funds and commodity trading advisors and other rapid-fire trading, and what we see, especially the ability to monitor what the expectations are for upcoming Fed meetings, do you think markets are maybe moving too quickly to price in changes in Fed policy? And do you think investors have become overly confident in what either they're trying to do in forecasting what the Fed is going to do or how they perceive what the market message is about what the Fed is going to do?
I mean, I would say with the coming of Chairman Warsh that they've become less confident about what they think the Fed will do and the direction that he really wants to go. I think he's pushed in some directions which sound pretty traditionally hawkish, especially the defense of the inflation target, his rhetoric that inflation is a choice. He's definitely taking responsibility for the ultimate inflation outcomes for the U.S. economy. But he said other things that make markets wonder. I think this issue about possibly changing the goalpost, possibly switching the metrics around the inflation target when it happens to be convenient to do so. I think that's something that's made markets a little bit nervous, and his reluctance to say anything about, 'Well, you know, we'll raise rates in order to get inflation down to 2%.' He maybe has other ideas about how to do that, maybe the balance sheet, but that's all pretty puzzling at this point exactly how that would fit together. And so I think markets are less sure about exactly how policy will proceed under the Warsh Fed.
Well, and you know, you mentioned some of the areas that there's a lot of uncertainty as to Warsh's plans, but of course he's created a task force for most of those. So what are your thoughts on that framework and maybe some of the members of the task forces? I mean, I think the reviews have generally been fairly favorable in terms of who he has put in charge of some of these task forces. But do you have thoughts on when we might hear anything and ultimately whether those will be seen as significant in how Warsh is thinking about the changes he wants to enlist at the Fed?
