The Fed Leaves Rates Unchanged: Our Analysis

LIZ ANN SONDERS: I'm Liz Ann Sonders. 

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

Well, hi, Kathy. Here we are back on the podcast after a week off, at least doing the podcast. You and I actually were both in Scottsdale recently speaking together at a Schwab conference. So I know that that has been on your agenda because we were together doing the same thing. Any other travels? What else has kept you busy in the last week or two?

KATHY: Yeah, I've been on the road in a couple other places, just visiting with clients and talking to some of the Schwab financial consultants and generally kind of getting out and about, and it's always good. I always enjoy talking to people in person. It still feels a little novel after the years off during the pandemic.

And so it's a pleasure to do it, but it is always a bit of a scramble to keep up on what's going on in the markets. How about you? Were you also in other places besides Arizona?

LIZ ANN: Yeah, well, I actually got to—you and I were in Scottsdale together—and I got there a day and a half, I guess, before you got there and had a couple of what we generically call retail client events. And those are always interesting. First of all, it's always nice to be in person and chatting with them one-on-one. A lot of these virtual events are very efficient, but it is nice to be in person. And the Q&A sessions, as I know you find in the events that you do, are always incredibly robust. 

And there's a lot of themes that always seem to punctuate these meetings that never go away—questions about the deficit and debt always seemed to be front and center, but unfortunately a lot more election-related questions. Fortunately for me and for both of us when we were on stage in Scottsdale, we were with our colleague and fellow Schwab podcast host with his WashingtonWise, had Mike Townsend. Like I always love when I'm on stage with you in a virtual event and somebody asks a fixed income question, I get to just sit back and keep my mouth shut.

I know you feel the same way, get anything election related and we can just kind of turn our eyes to Mike and say, "This is your bailiwick right now. Have at it. Have fun." And the retail events I did were with Mike as well. So a lot of election-related questions. Not just the obvious of fortunately not asking who we think's going to win, but what are the implications? And then more questions in the minutiae of policy and regulatory changes. So it's always educational even for us as colleagues of him to have that experience. And then virtual events too, did an international webcast, as we're taping this, this morning, and always interesting and in some cases slightly unique questions. It's funny, the international audience, they tend to be much more stock-specific. So lots of, you know, Magnificent Seven, Nvidia, AI-related questions. But other than that, everything has been good. Lots of good events.

KATHY: I agree. It's always a pleasure to be on stage with Mike just because it takes such a weight off your shoulders, letting him … and he does such a fabulous job, as well on his podcast, you know, WashingtonWise. But I'm also very glad when I'm on stage with you to let you talk about Nvidia and the Magnificent Seven and all the stuff that's going on in the stock market because I really don't have a clue what's going on over there.

LIZ ANN: Well, I heard you on, as we taped this, on Bloomberg TV today, and I did a hit a couple of hours later, and I heard you get a question about the market, and you said, "Well, that's for my colleague, Liz Ann," and they said, "Well, she's coming on in a couple of hours," so they actually teed up the question: "Not sure if you were watching Kathy on Bloomberg …" I said, "I sure was! I know what's coming, but ask me anyway."

KATHY: Yeah, I like to deflect those because honestly, as you know, equities aren't my thing. I always am glad to defer to you, especially in times when things are a little nutty, it seems.

LIZ ANN: Yeah. Although, you know, we're used to in our lives more volatility in the equity market, but these days, maybe a little bit less than was the case last year, but the volatility action has been in your world, not my world. I'm not sure that's going to last in my world. But it's been a bit of a reprieve.

KATHY: So now that we've had the Fed meeting this week, maybe volatility will calm down a little bit in the bond market.

LIZ ANN: And that is what we're going to spend the episode for the most part chatting about today is Wednesday's FOMC meeting. And for newbies maybe, that's the Federal Open Market Committee, by the way. I sometimes call it the "Federal Open Mouth Committee," given that there are so many more Fed speakers than was the case, say, under the Alan Greenspan era. But as a reminder, the FOMC has eight regular meetings per year, and this was the second meeting of 2024. And it's also the fifth meeting in a row without any changes to interest rates, with the final hike having been last July. So Kathy turning to you what is your or what are, I guess, your big-picture takeaways from Wednesday's meeting?

KATHY: So Liz Ann, my takeaway is that the Fed is trying its best to avoid doing damage to the economy as it heads towards lower rates. So it's going slowly and cautiously. Fed Chair Powell loves these driving metaphors, and he used that again today. So just to sort of be consistent with that, I would say the direction of travel for interest rates is lower, but we're not sure about the speed or even the final destination. So the economy's proving to be stronger than expected, and inflation's somewhat more stubborn than in the past few months. The Fed is trying to be cautious. It doesn't want to go too fast in cutting rates and reignite inflation, but it doesn't want to go too slow that it drives the economy off the road. So the Fed left the policy rate, the fed funds rate, unchanged, and that's a target range of 5.25 to 5.5%. But it still signaled three rate cuts this year. However, the Fed did two seemingly contradictory things.

It raised its forecast for growth and inflation for this year. But that's maybe mostly marking to market with what we've seen. But it also signals continuing rate cuts, didn't alter the rate-cut expectations. The most interesting thing I think the Fed did is raise the longer-run expectation for the so-called neutral rate. And that's what I refer to as the final destination on this journey.

So the neutral rate is the rate that's believed to be neither so high that it hurts the economy and sends unemployment higher, nor so low that it will allow inflation to rise. Now prior to this for years, that estimate has been 2.5%. The median estimate this time only adds up to 2.6, but what stood out to me is that seven members raised that estimate to 3% from 2.5 at the last meeting. And that compares to just four members having a 3% estimate at the last meeting. Now it seems kind of trivial, but I think what the Fed is telling us is that their expectation for the potential growth rate in the economy is actually higher than it used to be. And that's pretty significant because I think that's probably reflecting the idea that we've got better productivity growth going on. And maybe this is an offshoot of all the AI-related investment, or maybe it's simply that we're getting better labor force participation. But whatever the reason, I think that's something to keep an eye on because it does change the final destination for rates. There was a little bit of chatter about the balance sheet runoff at the press conference, and we know that the Fed discussed it at the meeting, but they didn't make any announcements on decisions. 

So I would expect that an announcement may come in May or June, and that the Fed at that point will say, you know, it's going to slow down the process of quantitative tightening to avoid causing liquidity problems in the financial markets. That may not have a big ripple effect, but it's another thing to keep an eye on. So I guess if I had to sum it up with that driving metaphor, we're traveling down the road to lower rates. But the speed and destination still to be determined.

LIZ ANN: You know, Kathy, you mentioned the labor force. I thought what was pretty interesting, especially in an election year where immigration is such a hot button issue and drives so many emotions in different directions, that he talked about it more objectively in the context of our country relative to other countries, the fact that it's been additive to labor supply and all else equal to the benefit of economic growth particularly as it relates to other parts of the world. I don't seem to recall much attention given to that by Powell specifically in past press conferences. Do you?

KATHY: No, I think he may have mentioned it once or twice, but like you say, it's a hot button issue, and the Fed tried so hard to avoid anything even vaguely political. But I do know there was a study or a paper by one of the Federal Reserve banks, and I don't know which one, that talked about the impact of immigration on employment and on the labor force participation rate particularly. So he may have been referring to that or he may have had that top of mind.

LIZ ANN: So you know, thinking especially about the very tight relationship between the 10-year yield and what stocks have done, very much in an inverse way last year, from around the point of the final hike in the cycle in July when we saw the big move up in the 10-year yield from under 4% to 5%, and that directly translated into an equity market correction. And then of course you saw the reversal that started at the end of October, and that provided a significant tailwind behind stocks. There's been a little bit more of a kind of a muted set of moves in the bond market, but I'm just wondering what your thoughts are broadly in terms of what the bond market is saying about forward expectations, but even maybe just the reaction in the immediate aftermath of the Fed's announcement and throughout the press conference. It was pretty muted, and I think some were surprised to see yields actually dip on the day. So maybe a specific answer to that question, but in a broader context as well.

KATHY: You know the market completely repriced, as you mentioned, with yields having moved up from about 3.88 or so in low last year and then moved back up to about 4.3 or so on the 10-year. But more importantly, probably, the two-year yield has repriced to reflect the expectation for the Fed not cutting as rapidly as people thought they would late last year and early this year. So when I look at two-year yields in the Treasury market, it kind of tells me what to expect for the fed funds rate a year from now. And so when I look at that now, it's roughly about 4.65 or so. That reflects the expectation of three to four rate cuts over the next year, which, I think, is more realistic than where we were earlier in the year. And then the 10-year yield just kind of hanging out, as you said, kind of a muted reaction because this really was where the market was priced. I think there were some fears that the result of the meeting would be more bearish for the market, but that didn't turn out to be the case. We haven't really changed course very much as a result of this meeting.

So I think the bond market's kind of reflecting that. And that's what I said at the beginning. Well, maybe we're getting a little bit calmer market now. Maybe things are priced more consistent with what the trajectory of Fed policy is going to be. That doesn't rule out some volatility based on the economic data we get. That could send us in either direction. But for now, we seem to have found a little bit of an equilibrium, which maybe will be a relief to the equity market.

LIZ ANN: Yeah, the only thing—I'm never a contrarian just for the sake of being a contrarian—but I think one of the sort of ironies that I think about right now, given that there seems to be a dismissal of recession risk, lots of questions last year about, you know, "How did everybody get it wrong with an expectation of recession in 2023? As you know, our view has always … we've had rolling recessions, but didn't think that there was a risk of a full-blown recession, and in turn that concern bled into concerns about earnings growth, which of course is the lifeblood of the equity market, and that turned out to be not unfounded but more grave a concern than what it turned out to be. We didn't get an overall recession. Earnings growth, although weak in the early part of the year, ended up rebounding in the case of the fourth quarter back into double-digit territory. So now we sit here, and everybody's sort of has in the rearview mirror any concern about recession, concern about earnings growth, but that to some degree probably represented to, you know, use the old term, "the wall of worry" and an environment where everyone's saying that there's nothing to worry about now. Everything seems great. Goldilocks seems, you know, locked and loaded. And I don't know—there's part of me that can't help that think that maybe that sets the expectations bar a little bit higher for disappointment. So it's just kind of back of my mind as we see some of these concerns that were pervasive last year get dismissed.

KATHY: Yeah, I think we've gone through this. You and I have talked about this so many times of how unique it has been, how different it has been from previous cycles because we just haven't had a pandemic to deal with and all of the consequences of that, not just domestically but globally as well. So I think we're all struggling and should have a certain amount of humility about our forecasts simply because it's easy to get it wrong when this current economic situation is just very different from anything that we've seen. Not only the actual pandemic and the reopening and all that, but the policy response has been very different in the U.S. than it has been in other countries. It's produced very different growth rates around the world. Impact on inflation has been up and down and sideways.

And so I think it's not surprising to me that people keep getting it wrong. And once you load up one side of the boat, there's always a risk you can tip the other way.

LIZ ANN: You know, I have one more question for you, because you mentioned, just in that last thought, other countries. One final question on Japan and moving away from, finally, away from negative-interest-rate policy. And that, maybe rightly so, grabbed a lot of attention because of how long it's been. But what were your thoughts on how meaningful that shift was?

KATHY: Well, I think it's meaningful, certainly a landmark, after all these years that Japan is no longer in negative interest rate territory. But the move was so small and so well telegraphed that the impact was pretty minimal. So the new target range for their base-lending rate is 0% to 0.1%. So it's still pretty close to zero. It's not negative, but it's pretty darn close to zero. I'm not sure that's going to change anybody's behavior in terms of investing or lending or borrowing. 

And the second thing is that the Bank of Japan in making the announcement actually sounded very dovish in the sense they're still continuing a lot of the other programs they've had in place to try to boost inflation, which has been too low for too long in their view. And that tended to offset the impact of the move on the interest rates. And actually, the Japanese yen fell for several days in a row prior to the announcement, because it could have appreciated, and then it fell back. And the day of the announcement fell over 1%, which is a pretty big move in the currency market. So you can see this is something that was definitely well telegraphed. Everybody knew it was coming. It was so small in magnitude that I think that the impact of it was really pretty limited. I think the Bank of Japan's going to have to do a whole lot more to shift the narrative around what's happening with Japan's economy and what that means for its bond market and for its currency. So for the moment, despite the fact that it was a big deal, it wasn't a big deal.

So Liz Ann, in addition to the article that my group published right after the Fed meeting that we'll link to in the notes here, you and Kevin Gordon, your partner in crime there on the equity side, published an article recently as well, which we'll also link to in the show notes. But in it, you talk about Fed cycles historically. And there's a ton of great charts in there in that article. But do you want to give us some key points to keep this cycle in historical perspective?

LIZ ANN: Sure, so the first table that we put in the report is one that, though updated, is very similar to one that appeared in our 2024 outlook. And it just looks at the history of full Fed cycles, and by full Fed cycles, it would be periods where the Fed was raising interest rates, and then some pause period in between the final hike and the first cut, and then the cutting period. And I won't go into all the details of what's in that table—you can take a look—but given that we are obviously in that pause period right now, we believe anyway that we are past the final hike in the cycle, but we're waiting for the first cut in the cycle. That is the most interesting one maybe to highlight. So there are 14 historical Fed cycles, which by the way is not a very large sample size. And the additional rub when trying to gauge what it has meant in the past for the market is that of those 14 prior cycles, in terms of the span of time that the Fed was in pause mode, goes from as short as 57 days in the late 1950s to as long as 874 days in the early 1980s when Volcker finally sort of slayed the dragon and stopped hiking.

So that's a huge range. So yes, you can look at an average, which I think is something a little bit under 300 days, but that doesn't really tell you anything given the long range. And here's the more interesting facet in terms of performance: Of those seven past cycles, you had seven periods where the stock market was up during the pause period, seven periods where the market was down during the pause period, and the range of performance went from about negative 26 to positive 26. So you can do averages, but I always sort of bristle when somebody says, "Well, the typical performance of the market is …" and then they'll cite the average, when in fact, when you have a relatively small sample size with a massive range, that's dangerous to extrapolate that into what it might mean. 

But we also look at maybe something more interesting, which gets a little bit more granular, that at the point where the Fed starts cutting interest rates, where there is more consistency is in the type of stocks that perform well versus don't. And in particular, if you break out those 14 past cycles into cycles when the Fed was moving quickly in cutting rates versus when the Fed was moving slowly, ostensibly when they were moving quickly, it was probably because they were trying to combat a recession or a financial crisis or some combination, defensive-type stocks tended to perform better relative to cyclical stocks, yet when they were moving more slowly, again, ostensibly because they weren't trying to pull an economy out of a crisis or recession, cyclical stocks tended to outperform defensive stocks. And we've seen this cyclical-leadership bias recently, and that may be internal to the market a further sign that the Fed is not going to be overly aggressive once they start cutting—and may be reflective of the shift in expectations that have already occurred just between January of this year and this week's FOMC meeting. 

And the other thing that we touch on in the report is the election, because there are two hot button issues in a year like this and represent two areas of uncertainty. And we slice and dice it in lots of ways and look at the history of elections and congressional control and what it's meant for the market. 

But the real punchline part of the analysis was, and you were on stage when we talked about this, at this conference in Scottsdale, if you look going back in kind of the modern era of the S&P 500® back to 1960, '61, I think, which also means you leave out sort of extreme eras like the Great Depression and World War II, if you had $10,000 in 1961, and you invested it only when there was a Republican in the White House, leaving congressional control aside, the $10,000 would have grown to about $100,000. If you only invested that same $10,000 when a Democrat was in the White House, that $10,000 would have grown to $500,000. I've actually seen people stop the analysis there and say, "Therefore, since the market has performed five times better when a Democrat's been in the White House, this is easy, wait and see who wins, only invest when a Democrat," but here's the real punchline and the moral of this story. If you didn't worry about whether the Oval Office was painted red or blue, and you just stayed invested, $10,000 in 1961 grew to $5.1 million. And that's sort of the mic-drop moment around elections and be really careful. And as our colleague Mike Townsend always says and has been reinforcing, this is an emotional year. It is going to be an emotional election. Try not to make that color your investment decisions.

KATHY: Yeah, that's something we talk about a lot, too. Because we get the question about the bond market and deficits and the Treasury market and how it reacts when different presidents are in office, and there's nothing really there in terms of analysis. It's one of those things where people understandably are concerned about, but in reality, there's nothing to hang your hat on in terms of the correlation between the political parties and performance in the Treasury market. There's so many other things going on that are of more consequence than that. It's always a good reminder to have that in the back of your mind during an election year. As you say, it's going to be very emotional and probably very interesting.

LIZ ANN: All right, well, looking less far ahead then, not to the election, but just to next week. So Kathy, what are you watching in terms of the markets or incoming data? What's on your radar?

KATHY: You know, this coming week will be after the Fed meeting. So there'll be Fed officials out speaking. The quiet period is over. So we'll get probably a good onslaught of comments and everyone kind of trying to explain their positions, various members of the Fed. And then a lot of economic data. The one thing I'm going to focus on as I'll be on the road again is the PCE and Core PCE. This is the reading that the Fed uses as its benchmark for inflation, the deflator for personal consumption expenditures. This is the one that they try to forecast and the one that they target, and that's coming out at the end of the week. That's going to be important because we know that the focus is on whether inflation is going to stall out here at this level or continue to fall. So I think that's the market mover for us.

What about you, Liz Ann?

LIZ ANN: Well, all of that, and we also have some regional Fed data out. You've got the Dallas Fed, Philly Fed, Richmond Fed, and Kansas City Fed economic data points. And those sometimes can have some interesting tidbits. We get a couple of housing-related data points, new home sales, and what we used to call the Case-Shiller measure of home prices. And given that we're starting to see some metrics within housing show a rebound, the housing market index and housing starts and permits, to get a better sense of whether this rebound is for real and is sustainable, I think, will be important. Another GDP revision and then claims. I think claims has the potential each week to be interesting. They've been contained, and that hopefully continues to be the story but something to watch for where you might pick up a change in trend with weekly data that you have to wait until the monthly jobs report to get it at a broader level. So that's what's on my on my radar. 

So with that, we're going to wrap it up for this week. Thanks as always for listening. And as always, be sure to follow us for free in your favorite podcast app. And if you've enjoyed this episode, which we hope you have, tell a friend about the show and/or leave us a rating or review on Apple Podcasts. 

KATHY: And, as always, you can follow our updates on X, formerly known as Twitter, and LinkedIn. I'm @KathyJones—that's Kathy with a K—on Twitter and LinkedIn.

LIZ ANN: And I'm @LizAnnSonders—Sonders is S-O-N-D-E-R-S—on X, or Twitter, and LinkedIn.

Next week, we'll be speaking with a well-known Fed watcher and economist Dr. Ed Yardeni, who is the president of Yardeni Research. But our conversation will involve much more than just the Federal Reserve. So stay tuned for what will definitely be a lively conversation next week.

For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find a transcript.