Are Interest Rates About To Spike? (Uncut) 02-14-2025

Are Interest Rates About To Spike? Key Risk Bond Market Signalling | Kathy Jones

I don’t think we’re going to substitute just outright by reshoring everything we get from China. You have a demand side push that could push up inflation from here. So the bond market’s going to reflect that risk.

And then you add deficits rising rather than falling to the equation. And on the margin, that will have some impact on yields as well. We’re joined today by Kathy Jones, chief fixed income strategist at Charles Schwab.

We’ll be talking about her outlook for the bond market and what’s going to happen next with currencies and yields. Welcome back to the show, Kathy. Good to see you again.

Great to be here. I think we can start by talking about the 10-year. If you take a look at what it’s been doing over the course of the last couple of months, first, we had a big rally into the end of the year.

I’m talking about the yield, that is. And then now it’s kind of hovering around 4.5. It peaked around 4.8 a couple of weeks ago. And certainly, the bond market was not very welcoming of Trump’s ascent into the White House in the fall.

But it seems like yields are falling again now. Are yields tracking inflation expectations or economic growth or political uncertainty all of the above, none of the above? What’s your take? I would say all of the above. So we had that big move up in yields.

It actually started in the fall when we had some upward revisions to the data for GDP and employment growth, and then kind of pulled back after reaching that 4.8 or so. And that was consolidating. And I think the reasons are many.

Fed’s on hold, so it doesn’t really give the market a lot of impetus to move one direction or another, because we think the direction their bias is to cut, but they may not cut at all this year, depending on the data. Economic data is strong enough that they don’t have to worry about policy being too tight. Employment growth is solid.

The policies, I think, are worrying for the bond market because they have the potential to raise inflation. But, you know, we don’t know how seriously to take every proposal that comes out. So the market is kind of waiting here to see what happens next.

Yeah. And on the inflation front, the five-year break-even inflation rate has been signaling that maybe inflation would stay sticky around where it’s currently at. Do you agree with that assessment that maybe inflation is going to stay stickier above the Fed’s 2% target throughout the rest of the year? It looks like that’s a pretty strong possibility.

Again, I go back to some of the policy decisions that we have tariffs, we have immigration changes, and those two components have the potential to be somewhat inflationary. And so if you reduce the size of the labor force and that presumably, if demand stays strong enough, that means wages are going to rise. It could give us some inflation impact there.

And of course, tariffs are at least a one-time price increase. It would get retaliatory tariffs. You know, we could see much more inflation on the import side than we’ve seen before.

So the risk is towards higher rather than lower inflation. So I would say, yeah, we could stick around this 2.5%, 2.6% for a while if some of these potentially inflationary policies really come to fruition. And what’s the Treasury going to do in response to what you’ve just said, stickier inflation? Yeah, I think the risks in yields are tilted to the upside from here.

And it doesn’t take much between those policies and the fact that the economy has just been very resilient in the face of a lot of things that have been thrown at it over the number of years. I would say that the risk is that we go back and Treasury yields and retest the 5% area on the 10-year. This is an interesting perspective.

Take a look at my screen, Kathy. Newsweek, President Donald Trump’s pledge to implement sweeping tax cuts could receive a negative reaction from the bond markets, triggering a significant market volatility, according to Nigel Green, CEO of leading financial advisory company, Devere Group. During the 2024 presidential election campaign, Trump vowed to introduce a series of tax cuts, including reducing the corporate tax rate to 15% to firms that produce their product in the U.S. Tax cuts and the bond market, is there any relationship whatsoever here? Well, over time, it’s hard to draw a straight correlation.

But the fact that we’re starting with a very large deficit and a very strong economy means that you put in tax cuts, whether they’re corporate or on individuals, particularly if we have all the tax cuts that have been talked about for individuals, that boosts buying power, spending power at the consumer level at a time when consumers are already spending at a pretty healthy pace. So you have a demand side push that could push up inflation from here. So the bond market is going to reflect that risk.

And then you add deficits rising rather than falling to the equation. And on the margin, that will have some impact on yields as well. Interesting.

Take a listen to what Scott Posen had to say on Fox. It’s about a 30 second clip. We’ll take a listen and react.

Trump critics say he always wants lower interest rates and he always wants a cheaper dollar. Do you have a riposte to that? Or maybe that’s true? Or what do you think? Larry, the president wants lower interest rates. And what he sees in my talks with him, he and I are focused on the 10 year treasury.

And what is the yield of that? So the purpose of lowering interest rates is to lower interest rates, the Federal Reserve. And I will only talk about what they’ve done, not what I think they should do from now on. They did a jumbo rate cut and the 10 year rate went up.

Now, I’ve seen this year, despite the growth estimates going up, 10 years coming down because I believe the bond market is recognizing that, as you and I talked about, energy prices will be lower and we can have non-inflationary growth. We cut the spending. We cut the size of government.

We get more efficiency in government. And we’re going to go into a good interest rate cycle. Okay.

I’ll just get you to respond to that before I ask my questions. Well, it’s a very optimistic view. So when you look at how everyone always wants to cut the size of government, everyone always wants to get a more efficient government, federal government, local government, et cetera.

It’s how you go about it and whether you can accomplish that. So far, we’ve seen a lot of reductions, potential reductions in workforce at the federal level, ending some agencies or potentially ending some agencies. But you only have 3 million federal government workers out of 166 million workers.

And if the average worker in the federal government makes $100,000 a year, let’s say, you’re not going to get $2 trillion in deficit reduction even if you cut the entire federal workforce. So we have to see how are they going to cut spending? What’s actually going to be done before we can make a judgment on that? And then on the inflation front, there’s also the very optimistic view that you can be very energy-centric on reducing inflation. And it relies on getting production up to even higher levels than it already is domestically.

It’s already at record levels and driving the price down. Well, that depends on whether the investors in the energy companies want those companies to increase production and potentially drive down their own profits. Seems unlikely.

What we’ve seen over the years recently is investors don’t want that. They’d rather get their dividend payments and see, well, prices hold a little higher, even if it means a little less production. So we’ll have to wait and see what they can accomplish.

But I’d say this is a very optimistic view, and we’ll have to get much more in the way of details in order to find out exactly how this kind of miraculous economy is going to develop. Okay. Well, this is what Trump said.

This is what Scott Bissett was referencing. He said in a video to the World Economic Forum in Davos, I’ll demand that interest rates drop immediately. And likewise, they should be dropping all over the world.

He didn’t call out the Fed Reserve in particular, but I think we know he was talking about the Fed amongst other central banks. Does that statement factor into your analysis at all, Cathy? I know you were just talking about yields potentially going to the upside as a risk, but here we have the president saying he’s demanding interest rates go down. Well, one person can’t drive the entire global bond market, right? So on the one hand, in much of the world, interest rates are still falling.

We do see bond deals kind of edging down. Europe is still growing very slowly, and the European Central Bank is cutting rates. We’re seeing low interest rates in Canada and in many places around the world.

Certainly China’s not growing very fast and their interest rates stay low. So he’s got the global bit on his side, but domestically where it matters for the U.S., he can’t demand interest rates go down. You have to see inflation, inflation expectations come down, and then 10-year yields will come down.

At the moment, we just don’t see the likelihood of that happening anytime soon. What happens if tariffs are implemented on a more wider scale? The day that Trump announced 25% tariffs on Canada and Mexico and then quickly rescinded them after a deal was supposedly struck with Canada, the DXY spiked dramatically on that day and then later came down. So the concern or assumption here is that if tariffs were implemented, the dollar could spike or have a bid, at least in the short term.

Are you bullish on the dollar then? Yeah, we see the dollar staying strong for that reason. Well, for several reasons, but certainly tariffs typically what you see is the country that’s imposing the tariff sees its currency go up to offset the price impact of the imports from the country that they’re putting tariffs on, and that’s one driver behind the dollar strength. But behind the dollar strength also is the strength of the U.S. economy relative to the rest of the world and the wide interest rate differentials.

We’re still seeing the Fed, even if the Fed cuts another one or two times this year, which we’re not sure that will happen, but even if they do, we’re still looking for rate cuts in much of the rest of the world. So those interest rate differentials really favor holding the dollar. What happens then if we have a rush into the dollar? Does that put pressure on yields to the upside? No, it shouldn’t.

I mean, if we see the dollar rising, that should be a bit of an offset for the potential inflation impact. So it should be good news for the bond market. Although again, it’s typically on the margin, it would have to be a very, very big move, I think, to move the bond market significantly off this kind of range that it’s in.

Let’s take a look at news from overseas. So as you know, the Bank of Japan has been embarking on a, let’s say, slightly different monetary policy than the U.S. Federal Reserve. Japan’s borrowing costs now exceed a 14-year high as this new wave of inflation has been hitting the country.

Take a look at my screen here. This is the Financial Times. I wonder whether or not investors are going to be flocking into Japanese assets now that the interest rate in that country is higher than it was before.

And certainly the Bank of Japan is looking like a little more hawkish than the Federal Reserve and other Western central banks. Are we going to get a reverse carry trade here where we have an unwind of assets from the West moving into Japan? Well, I think there probably will be some movement to Japan, but I think some of that will be repatriation of dollars invested abroad by Japanese domestic investors. But again, they’re at a 14-year high, but it’s still very low, those bond yields in Japan.

So I don’t know that they’ll attract a lot of foreign capital. But I would say that, yeah, you could see some Japanese investors repatriating some of their foreign investments and to put them into Japanese bonds or Japanese investments. If the economy is looking vital enough to see those interest rates rise, that makes the carry trade a little less attractive.

So we could see some movement in that direction. Japan is certainly the exception to the rule in most of the global economy right now. Would you be looking at a long yen trade versus a dollar pair? I think that’s a trading possibility.

So I think you can be in and out of that trade. I don’t know that I’d be in it for a long-term position. How are corporate spreads looking, Cathy? Are we seeing any volatility or risks on the corporate front? Are we seeing any fears of a recession or defaults on the horizon just from looking at spreads? No, remarkably stable, low, steady corporate spreads in the investment grade area.

We’ve seen some widening in the high yield area, but they’re still very, very low. I would think that as we move forward, depending on what industries are affected by tariffs, we could see some widening in spreads as some of the companies that would be caught in the trade war could be affected. We may see some widening in spreads from here just as that ripples through the various sectors of the market, but so far behaving amazingly well considering all the volatility that we’ve seen in the equity market and considering all the uncertainty about policy.

Okay. What about concern or uncertainty surrounding geopolitical news? So take a look at this. This came in today.

Ukraine may be Russian someday, Trump says, as the US ups the pressure on Kyiv and allies. He wants to make a deal with Putin and Zelensky. It hasn’t happened yet, but he’s putting pressure on the Ukrainians.

The idea here is that if we have a de-escalation of the conflict in Ukraine or perhaps even Gaza or both, there could be a flood of capital away from safe havens, Treasuries being one of them. Do you see that on the horizon? Well, I’m not placing a high probability on that just because a lot of this is very potential and very hopeful. And I don’t know how well it would play in the rest of the world if Russia were to get a significant hold on Ukraine.

What would the rest of Europe feel like about that with the NATO countries that are closer to the border there? So I’m not sure that’s going to alleviate all of the concerns. So again, it remains to be seen. Obviously, the dispute in the Middle East is another big area of concern.

Nobody wants to see it re-escalate from where it is. But it so far hasn’t had any impact on the energy market. So if you de-escalate that, we’re still not seeing it ripple through very much in terms of the global economy.

I think it’s going to take a lot to reverse the flows that have come into the U.S. If Trump, let’s say, going back to tariffs, for example, if Trump, let’s say, implements stricter tariffs on China, which is kind of the main focus of the trade war. Take a look at my screen here. Thirteen percent of U.S. imports come from China.

If we were to see, let’s say, this graph change, so we have more or perhaps less, in either direction, more or perhaps less of the goods that the U.S. consumes or imports coming from China, would that change capital flows? Would that change the balance of payments in any way and ultimately affect the bond market? Well, I’m going to make the assumption with China that, as with the last time around, tariffs, which were imposed and kept by the Biden administration, that you’ll just see a lot of it shift to other areas. So a lot of the exports out of China will go via, say, Vietnam or through Mexico or some other way. So you’ll see companies moving around to adjust to the tariffs.

I don’t know that it’ll have a significant… Sure, we could see some change in our trade deficit with China, but we probably will just see it expand elsewhere to fill the gap because a lot of these things are not things that would make sense for U.S. manufacturers to make the investment to produce domestically, even if they could, and that would take a very long time. So I don’t think we’re going to substitute just outright by reshoring everything we get from China. Chances are it will just move around the globe.

Okay, so investment implications of our discussion. So yield curve, do you see that steepening continuing? Yeah, I think the general trend is steepening still, unless we get some very sudden evidence that the economy is slowing down or that inflation is suddenly falling or some sort of development that’s unforeseen at this stage of the game. Yeah, steepening is still in our playbook.

There’s been a lot of talk of stagflation being a possibility, especially from tariff stagflation being lower growth and higher inflation. We talked about the lower or higher inflation front, but what about lower growth? Is stagflation a possibility for 2025? Well, I think maybe for 2026 more than 2025, but I do worry that some of the policies will slow growth. So not only tariffs, but also the immigration changes.

So if we get more in the way of widespread deportations, this is going to affect some industries quite a bit. I think constructions and the restaurant industries, service workers in various areas, healthcare workers in the service sector. So certainly agriculture.

So you get this absence of workers, production goes down and or people who are here who feel that they may be targeted for deportation because they’ve been waiting for their papers and they can’t get them now are withdrawing from either work and or consuming. And so that can definitely slow the economy. We’re hearing right now they’re more anecdotal reports, but when you look at the federal reserve district bank report surveys, we’re watching closely to see what they’re saying about employment and how difficult it may be to get workers in certain areas.

And what does that do? That slows down growth. So we’re concerned that immigration reforms that have been put into place and continue to be put into place can slow growth because you have fewer workers, you have less output. Meanwhile, tariffs could boost inflation.

So stagflation is a possibility on the horizon. I wouldn’t say it’s the highest likelihood in 2025, but over time we could see something similar to that. Well, how does the bond market typically behave during a recession? I know in 2008 yields fell, in 2020 yields fell, in 2001 I think yields fell as well, but the Fed was involved in cutting rates and all of those cycles.

But if you take the Fed out of the equation, would yields still fall? I think they would still fall if we had a recession, but we’d probably get an inverted yield curve. But I think there is also a floor that’s higher in this cycle than it was in those previous cycles because we were coming into certainly the last couple of downturns with much lower interest rates, much steadier inflation, lower and steadier inflation. So now we still have this legacy of the high inflation.

We have the potential for the sort of stagflationary environment that may not allow yields to fall that much. Well, what’s your explanation for why in this cycle currently, Kathy, that we have the Federal Reserve cutting rates ever since September, they paused last time like you talked about, but the bond market has been kind of not following the Fed cuts to the point where we have people talking about why this divergence is happening. What’s your explanation for why we have this divergence? Yeah.

So if we go back to September when the Fed made that jumbo rate cut, remember we had weaker data. It looked like economic activity was slowing down. It looked like the labor market was softening.

We’re still in the midst of declining trend in inflation. And then almost as soon as they did that cut, the next jobs report, the next employment report showed big upward revisions. It was a big surprise to the upside, showed big upward revisions to the previous couple of months.

So we’d underestimated to a large extent how strong the labor market was. And then subsequent to that, we’ve had pretty healthy numbers, particularly on the labor side. And then we get the potential for stimulative tax cuts, tariffs, and that added to the concern in the bond market.

So I look at the term premium and a term premium has really been one of the big drivers of the rise in long-term yields. And so I think the explanation is both economic and on the economic side, just the surprises have been to the upside and then the potential concerns about inflation on the long end of the curve. A reporter actually asked Powell this question a couple of conferences ago.

And the question is, I’m paraphrasing here, but if the 10-year yield continues to stay high, which is to say diverging from federal reserve monetary policy, would the Fed actually have to look at the bond market in order to make policy? In other words, if the bond market is doing one thing, they can’t be doing another. Do you think they’ll be impacted and influenced by the treasury market ultimately? I’m sure that they’re taking it into account. I’m sure that they take inflation expectations into account and that is a big driver of long-term yields.

Now, when we look at, say, the treasury inflation protected securities market, the TIPS market, we have seen those yields move up and the five-year, five-year forward break-even rate, which is something the Fed talked about in previous cycles. So I think they will take it into account because the last thing they want to do is cut rates and send a signal that they’re stimulating at a time when the market believes that there’s too much growth, too much demand-driven or supply problems or inflation pressure. So I think they’re going to take it into account.

They’re still going to use their judgment about where the economy is going, but I think they definitely have to look at it. Do you think that the bond market is basically doing quantitative tightening for them right now such that the Fed no longer needs to engage in tapering to the same extent as they would have if the yield was below 4%? Yeah. I think really the quantitative tightening is having limited impact on the market, but the market is… You would think that with rates moving up that we would see a tightening in financial conditions.

We’re only seeing it in selective areas. So the high mortgage rates are slowing down the housing market and high borrowing rates are presumably having some impact on lower-end consumers and their ability to borrow to buy cars and credit card rates being very high. But in aggregate, financial conditions still stay pretty easy.

As we mentioned, those credit spreads are very, very low and not sending a signal. Any company that can access the capital markets is in pretty good shape in terms of accessing financing, private equity and private credit, providing plenty of financing out there. So I would say that when you look at financial conditions, really not at a point yet that is signaling it’s very tight, that policy is very tight.

So I think that that’s also something that the Fed has to take into consideration when setting policy. Let’s just take a longer-term perspective, like really long here. I’m just going to show you the 10-year chart, except going back to the late 70s.

Now, as you know, the structural trend over the last four to five decades has been down for the 10-year, troughing around 2021. It looks like there’s been a bit of a rebound in the last four years. Are you longer-term bearish on bonds? In other words, do you expect or see any scenario in which the 10-year rises back towards its pre-1990s level of double digits? Is that like in the cards for the current economic environment? I would think not.

So a couple of reasons. One is our potential growth rate is much lower now than it used to be. So a lot of that was kind of uniquely driven by things that accumulated over the years.

And the energy price shocks were certainly a part of that. But also part of it was demographics were just completely different now than they are now. So I would say our potential growth rate really has maybe moved up a bit because of productivity, which is not uninflationary, but I don’t think it’s anywhere close to the level that it was when we were hitting those inflation levels that drove rates up and forced the Fed in those days to have a very, very tight monetary policy.

So no, I would say I pay attention to nominal GDP growth. It’s running about 5% now. I think that’s kind of the upper end of where it can go.

And then just sort of fun facts. When you look back 100 years at bond deals, the average is around 4.5%. So we may be just in the midst of a very, return to a very long-term average in terms of bond deals. So investors might ask that, Cathy, if we’re returning to a long-term average of 4.5%, we’re even just tracing, like you said, the upper band of the GDP growth rate.

Not why, but where do we go for yield? Because maybe that’s not high enough for me. Well, again, that’s a treasury. And I do think there’s some upside here, 5%, 5.25% is not out of the question.

But if that’s not high enough for you, you can look at investment-grade corporate bonds. We’d be wary of the high-yield bond market at these levels. It’s just priced for perfection.

And we’d be a little bit concerned there, certainly limited allocation there. Investment-grade corporate bonds, even though spreads are low, credit quality is good, corporate profits at an all-time high, cash flows are good. I would say that’s a place to look for more yield.

If you want higher real yields, you can go to the TIPS market. Those real yields are pretty attractive right now, 2.5% area. That’s a place that I would look as well.

We do want to stay up in credit quality. So we’re a little bit concerned about dipping down too low, but even in the ag, you have an all-investment-grade portfolio, basically, or all-investment-grade index that’s probably with total return and a little bit of alpha, you could add by selectively picking certain sectors of the market versus others. You probably get 5, 5.5%, 6% returns over time.

Okay. And so just given what you’ve just said, can you assign an allocation preference for fixed income portfolio for 2025, at least? Yeah. So almost always when we look at it, we look at core and then the higher risk bonds.

So we like having the bulk and core bonds, the treasuries, the ag-like investment-grade corporates. If it works for an investor, municipal bonds, those after-tax yields can be pretty attractive right here. And then a lower allocation, maybe 20, 25% to the riskier segments of the market, the higher bonds, preferred securities, things that we know are less liquid, more volatile, but do have higher yields.

We’d probably limit the allocation to somewhere in the 20, 25% area. Excellent. All right.

Well, actually, before we go, what about equities? The question I have is, do you think that the cost of capital for the equities market overall is going to stay sufficiently low in the foreseeable future such that returns on equities would actually make a lot of sense? Well, it’s difficult right now because that equity risk premium is now lower than the bond yield for the first time in a long time. So I do think price matters when you’re investing. Your starting price matters in terms of future returns.

So yeah, we wouldn’t say never hold equities or be all in one or all in another, but our house view is you want to be pretty cautious to make sure that you’re investing in companies with strong cash flows, strong earnings power, well-positioned because it’s the weaker parts of the market that are more vulnerable if we go into an economic downturn from here. I think a lot of equities investors are maybe looking forward to the prospect of returning to a zero interest rate environment, which is what we have for quite some time. You’re shaking your head.

Nope, that’s not happening. Oh, I don’t see it happening anytime soon. Well, first of all, I hope not because that’s usually because there’s some sort of catastrophe that’s happened and we don’t want that scenario.

But secondly, it’s a different world now. I think we have turned a corner. We would have to have a very dire economic situation, very dire kind of downturn in the economy to get the Fed back to zero.

And at this point, I can’t tell you what would produce that kind of outcome. So given the resilience of the economy, I would say no, zero is not on the horizon. Great.

Well, thank you very much, Kathy. Where can we learn more from you and follow your work? You can follow us on schwab.com slash learn, learn tab, the dropdown menu and all things bonds you can find. And then I’m on social media, on X at Kathy Jones, Kathy with a K and also on LinkedIn.

Okay, we’ll put the links down below. So make sure to follow Kathy on X and LinkedIn and as well as the Charles learning portal. We’ll talk about your work another time.

Take care for now. Kathy, thanks for joining the program. Thank you, David.

Thank you for watching. Don’t forget to like and subscribe.