KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: 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, hello, Liz Ann. You know, when we spoke last week, we didn't yet have the latest inflation numbers for June, but now we have the CPI, the Consumer Price Index. That was up about 2.7% from a year ago. What was your take on it? Because I think the market reaction was a little bit different than what people thought it might be.

LIZ ANN: Well it was kind of a funky day to use a technical term in the market because of, you know, tech's outperformance boosting an index like the NASDAQ, but materials' significant underperformance hurting an index like the Dow. S&P was sort of in the middle, so a little bit of a mixed bag. But I don't remember whether we talked about this last week. I know I've spoken about it in different forums that I think we're at the stage, especially with the inflation data, maybe equally with the employment data, that we've got to look beneath the surface of just the headlines, especially in the case of inflation to try to pick up the tariff impacts. 

And one might say by just looking at the headline, "Nothing to see here, not a big deal," but you go inside the numbers, and you are starting to see the impact. So the increase in the CPI was led by a pretty decent jump in core goods prices, ex-autos. In fact, core goods ex-autos, was the biggest gain in three years, and especially for imported goods. Obviously, that's where the tariffs hit. And it's you know, it's big areas, it's appliances, it's apparel, toys, sporting goods, furniture. And then if you look, additionally, at goods, that are not subject to tariffs, those were actually flat to down a little bit. So we do have this dichotomy within the inflation data, and we're now able to start to pinpoint where we're seeing a tariff impact. And then the offset of lower vehicle prices, that's probably not going to persist. 

We've also had an offset of services' prices. And one big category of CPI are the shelter components, owners' equivalent rent being one of them. And there's been downward pressure in those areas as an offset to some of the upward pressure on the goods side. But I think some of that is set to fade, too. So we might start to see it in the headline numbers, not just under the surface. The past history shows that takes about three months for tariff increases to really start to show in traditional inflation data. And this inflation data was through June. 

So I think the next few reports are particularly important. The market has had a lot of momentum. I think that you and I talked about it certainly last week. Retail traders have been a big driver of this market. You see it in which cohorts within the market have been outperforming the most since the early April lows. And there's actually a Goldman Sachs basket called retail favorites. And that's been one of the better performances, the meme stocks, and interestingly, almost every category of shorts. So this is heavily shorted areas of the market. Typically it's institutions that are doing the shorting. And when they start to perform well, it usually means that there's been forced short covering which is in keeping with the momentum in the market. And that makes me think that, although I think there's some complacency that has built in, especially around things like tariffs and their impact, I think the so-called "pain trade" is probably still higher because a lot of the large speculators, the big institutions that are active in the futures market, show that they're still more on the risk-off side of things versus the risk-on. And so, the pain trade meaning that they might be forced to adjust their positions. So I think there is some complacency. I think that in and of itself is a bit of a risk, but again, I think the pain trade is still higher. 

How about you? What were your thoughts on inflation and maybe as it relates to near-term Fed policy, which is on everybody's mind.

KATHY: Yeah, I agree with you. It looks like we're starting to see the tariff impact kind of work its way into the inflation numbers. And for all the reasons you cited, I think one of the things we just kind of look at the line chart, right? And you can see an upward turn after several months of declining from those peak levels over the last year or so. It's gradually, both at the core and overall level, starting to turn back up north of where the Fed would like it to be. You know, it didn't reach 2% yet. So now it's starting to turn up at about 2.5% to 3%, which is not is kind of discouraging if you're hoping to hit that 2% target. 

And I think that that definitely leaves the Fed in a difficult position because they, you know, are still too far away from their inflation mandate to cut rates. And there's obviously tremendous amount of pressure on them to cut rates. But it would be very difficult to succumb to that pressure unless the employment picture changes. And that's still, I think, a possibility as we get into the Fall. The labor market's kind of stagnant right now, and that's not good. There's not a lot of hiring, but there also hasn't been a huge amount of firing. But we are starting to see some of those layoff numbers pick up.

So if we start to see the unemployment rate tick up and a couple of months in a row, two tenths of a percent, three tenths of a percent heading back towards 5%, I think the Fed would react to that with a rate cut. But right now the evidence just still isn't there. Despite all the pressure that's coming from the White House and elsewhere, the Fed just doesn't have the ammunition if they're looking at the data to say, "Yeah, we're on our way to achieving that goal on inflation." Maybe when the other half of the mandate kicks in and unemployment starts to rise, then they'll have enough evidence to do it. We're still looking at September as a possible timing of a rate cut. But frankly, all of the pressure from the administration is actually more likely to backfire than anything else. You start to raise inflation expectations if you think that the Fed is going to be influenced to lower rates when it's not appropriate. And I think that that's something that sort of gets missing in the politics of all this is the market knows. The market knows what the numbers are, right? And if there's a belief that the central bank is losing its independence, that's going to be bad for bonds, not good for bonds, if it cuts rates. I think that's something we just have to take into consideration. Right now, Fed's holding steady, I think maybe September.

LIZ ANN: I was traveling today, so I didn't see whether there was any movement of the needle in terms of rate cut probabilities, either for the July meeting or the September meeting in the aftermath of the CPI report. 

KATHY: It actually went down a little bit. It went down a little bit, which initially was perplexing because initially people said, "Oh, the core inflation number is a little lower than we expected, rah rah!" And then everything kind of turned around and bond yields went up. And the expectations for a cut in the near term went down again. So yeah, I think the market read through the numbers just as we talked about.

You know, I think the other component that's really interesting right now that isn't getting maybe talked about as much is the rise in global yields. And, you know, Japanese yields keep hitting new highs. Now, you know, the yields are still low, but they're still rising. 

LIZ ANN: This is mostly out the maturity spectrum, right?.

KATHY: Yeah, yeah, their long-term yields are rising. The 10-, 20- and 30-year bond yields continue to tick higher highest levels and, you know, over a decade or so. And we're seeing it in the long-end of most developed markets and I think that's a reflection of worries about fiscal responsibility or irresponsibility, rising debt levels at the government level and not just rising debt levels but the apparent unwillingness of some governments to address it. So, you know, we've had this in Japan for a long time now that they're kind of letting loose their grip on the bond market, those yields are moving up because their debt-to-GDP is over 200%.

And ours starting to drift higher as well because we're not addressing the high level of debt. And, you know, we're seeing the ratings agencies downgrading government debt. So, you know, it is concerning. And I think our bond market is being pulled along with the global tide as well. So, again, the Fed could cut rates. I'm not sure long-term yields have come down very much if this global tide is rising.

LIZ ANN: Is it still the case that most of long Japanese bonds are held by Japanese, by local investors?

KATHY: Yeah, yeah, and the government owns a lot as well. So the government still owns about half of the bond market. So they still have a pretty tight grip on it, but they've been trying to let it loose a little bit. And I think much of what's happening in Japan is just repricing to reality. It had been suppressed for so long, it's trying to reprice to a more reasonable level. But yeah, domestic investors still own a lot of Japanese bonds. 

I think the worry for the rest of the world is they've also been big buyers of non-Japanese bonds, US Treasuries, and Euro-denominated bonds, et cetera. And if they can get higher yields at home without taking currency risk, or on a hedge basis, get the same yield or higher at home, why would they go elsewhere? And then we've been living off of those inflows of capital for a long time. So I think it's all sort of conspiring right now to pull those yields up. It's not a crisis, but it's not a good trend either. And that, again, puts central banks in a tight spot, because they don't want to be seen as fueling inflation pressure at a time when those long-term yields are already starting to edge up.

LIZ ANN: Yeah, speaking of yield differentials, what are your latest thoughts on the dollar? The DXY index, which is just the ticker symbol for an index tracking the value of the US dollar doesn't have really the right calculation in terms of what our key trading relationships are. I think you look more at the Fed's broad trade-weighted dollar, which I know the DXY has had a little bit of a pop, less so for the broad trade-weighted dollar. But what's your latest thoughts on our currency?

KATHY: Yeah, it has had a bit of a bounce. So I look at, if anyone has access to a Bloomberg terminal, the closest to the Fed's trade-weighted dollar is the Bloomberg Trade Weighted Dollar index, which does a pretty good job of matching up with the currencies, weighting the currencies of countries we trade with the most. And it has had a bit of a bounce here, but overall, it's down about 10% from its recent high and we do look for it to go down another 5% or so over the next year and some of that is simply we have a wide trade deficit and we appear to be pursuing policies to try to narrow that, and one of the quickest ways you can narrow trade deficit is drive down your currency and so there's been no job owning, no interference from the administration as the dollar's gone down. I think there's also been a bit of movement away from dollar assets. Now, I don't think it's been a huge move, but given all the trade conflict and all the things going on, seeing foreign investors sort of say, "Well you know, maybe we should look elsewhere." Now, with the NASDAQ going up, we might reverse that flow. don't know. You would have a better feel for that. But we still have the booming tech sector there.

LIZ ANN: Yeah, part of the reason for I think some of the performance and leadership and now that it's earnings season, focus on what has been an improvement in terms of the tech-sector outlook is, in part, due to the weaker dollar because of all the 11 sectors, tech has the highest share of its top line growth that comes from overseas sources and all else equal a weaker dollar is to the benefit of that forward-looking earnings streams. So I think there's lots of other reasons why I think tech and anything AI-related continues to do well because we… I think this, we've talked a lot about, you know, the economy these days being brought to you by the letter K again with the haves and have nots even at the consumer level. But from a capital spending, rightly so, lot of discussion on constraints on capital spending and companies that have put themselves in timeouts on any long-term investments, but that's decidedly ex the AI type spend and that's still, you know, full bore. And so I think it's another reason why you're likely to see the translation of haves and have nots in the economy filter its way into equity market behavior as well.

KATHY: Well, certainly if you're an engineer who can work on AI, there are people willing to pay you enormous sums of money to do that according to the reports. It is sort of mind boggling when you hear those numbers.

LIZ ANN: Jensen Huang from… head of Nvidia just leapfrogged Warren Buffett today I saw with his with his net worth. So yeah, it's a brave new world.

KATHY: Yeah, I saw Meta's spending up to $100 million to hire engineers who can build out their AI. It makes me think I should have gone back to school at some point, just to develop those skills, but a little late for me, I'm afraid.

LIZ ANN: Ditto. I'm still of the, if something doesn't work, unplug it and plug it back in and actually usually solves the problem. But I have to admit, I am spending a little more time experimenting with large language models and it is fascinating, it really is.

KATHY: Yeah, I you know, it's just right before we started this podcast was using AI to research something and yeah, it spits out some pretty interesting information and some I hope it's accurate. 

LIZ ANN: Yeah, I guess they call it the hallucination rate is still fairly high. I mean, low single digit kind of percent. It depends on what your source is, what the feeder source is. You do still have the risk of garbage-in garbage-out with a large language model. But nonetheless, it is fascinating how quick the adoption is and how especially maybe young, more tech-savvy people are figuring out how to use this. I do worry a little bit about it, like whether high school students into college students are going to ever actually know how to write on their own. 

KATHY: I think that ship sailed a while ago from my observation. That's been an ongoing thing, you know, but there's so emphasis in education on STEM as opposed to liberal arts. I think that's been one of the factors as well. But so we've talked about tariffs, talked about the dollar, earnings seem to be going well, AI. But, you know, I want to think a little bit out towards the end of the year now.

There is so much going on between now and the end of the year that we have to take into consideration. And we just did our mid-year outlooks but I'm already questioning my mid-year outlook, which was fairly bland as it was because I didn't want to, didn't really have confidence to go out on a limb, but I'm really wondering if we should have been even more careful about the long-end of the bond market, the way things are developing. Do you think if bond yields continue to trend up here, we had the 30 or above 5% again, if this trend were to continue, how do think the stock market would take it?

LIZ ANN: I think some of it is, first of all, it's the why. When bond yields are trending higher because of inflation versus because of growth getting stronger, that's much more of a negative backdrop for the equity market. When bond yields are keying more off growth and less off of inflation, then you have that more positive correlation. I think if we're right that we're not out of the woods yet from an inflation, standpoint and that the tariff impact is just starting to filter its way into the inflation numbers and the 10-year continues to trend higher, I think all of the sequel that probably puts downward pressure on the equity market. And also if the speed factor, too, as we all saw and learned in that, know, fateful week between April 2nd and the intraday equity lows on April 9th, it was the speed of that move in the 10-year.

I think it was what, just two trading days where you added a half a percentage point. So that tends to spook the equity market, too, if you start to get a move that is not benign from a speed perspective.

KATHY: Yeah, I think that that's my beginning to be my worry that there's more upward pressure between the inflation numbers, between concerns about budget deficits and just a general global trend towards higher rates, weaker dollar. I tend to think that if there's a risk, it's that yields go back up and test some of those higher levels. And I think that would probably not be great for the stock market.

LIZ ANN: Yeah, and that brings back what I mentioned earlier. I think that there's just some complacency here. And that, again, in and of itself can represent a bit of a sentiment risk.

KATHY: Let's look ahead to next week, Liz Ann. What do you think is important for investors to be watching?

LIZ ANN: Well, we get the Producer Price Index, which is before this episode will air, but after you and I are taping this episode right now, so we'll have to see what it corroborates or doesn't. But again, this is the kind of backdrop where, take out your fine-tooth comb, because it's the details therein that's more important. And then also once you get, once you have both the Consumer Price Index and the Producer Price Index, you can start to map the component parts of those to the Personal Consumption Expenditure Price index, which is the Fed's preferred measure. And that has less of a weight in the shelter component. So we could start to see more clearly the impact of tariffs without that offset from some of the shelter components. 

Let's see what else we're getting. Retail sales, I think that's going to be very important because we've seen not just a bit of a trend down there, but when we got the most recent revision to first quarter GDP, which was a further downward revision, the biggest hit in that downward revision was the consumer spending piece. So I think retail sales would be important. You know, claims, these weekly claim numbers continue to be important. The initial claims headline readings have not been worrisome, but the continuing claims representing people who initially filed and then continue to be on receiving unemployment benefits that's at a cycle-high right now. So it's very much in support of what you mentioned earlier, which is a low-hiring low-firing kind of backdrop, but that's another under-the-surface way to gauge the health of the labor market and we get some housing stuff with moves and yields. I think that's important. 

We get the housing market index, which is a builder sentiment index out of the National Association of Home Builders. We get housing starts, building permits, home sales, see if there's any movement there. And then we get the S&P Global version of the purchasing managers indexes. So you've got Institute for Supply Management versions, which are maybe a bit more widely followed, but S&P Global's version, both for services and manufacturing have been increasing in popularity. So that's what's on my radar. How about you?

KATHY: Yeah, I know you follow those housing statistics really closely. And I think that it's one of the anomalies about this cycle, that housing just continues to be stuck in the mud because mortgage rates have not come down. We have seen rents come down after surging. So that's encouraging in terms of people getting a little bit more mobility and being able to move around, find housing, and maybe more affordable levels. 

We're starting to see some weakness in some housing markets regionally, I think. But it's still not a lot of activity. I sit there and I think, "Are mortgage rates really all that high?" I mean, relative to history, they're high relative to where we've been for the last 20 years, but they're not all that high in terms of long-term history, just like real interest rates are sort of back to the very long-term trend that was established before the housing crisis, before the great financial crisis. I wonder if, know, do you think we'll see house prices adjust, or will we just stay stuck?

LIZ ANN: That's been the problem is that you've got sort of three legs to the housing affordability stool: the mortgage rate, the home price, and then your income levels. And income levels have been pretty decent, but you haven't seen sufficient downward move in prices, especially for existing homes, because there's been such a constraint on supply, because so many existing homeowners have locked in mortgages at much lower rates. So there's no incentive for them to move. So I think you need to see probably movement in two of those legs, not just mortgage rates, but prices coming down to start to free things up. I don't know if you saw the data also that came out, I think I put some charts on it on my X feed today, but the average age of buyers of homes has gone up quite a bit, especially for first-time homebuyers. And that very much reflects the affordability problem.

KATHY: Yeah, and it just doesn't look like it's going to get a lot better anytime soon unless those house prices really can start to come down. So it's… I can understand the generational frustration that's out there. I just don't know what the what the change will be unless we just get a lot more housing construction at affordable prices, which, you know, may be where we end up. 

But, one thing I'm going to keep an eye on is just the comments from the various Fed officials. You know, Fed's in the news all the time these days. And we are getting closer to the end of Fed Chair Powell's term, which a lot of people are talking about. So it's going to be interesting to see what these various speeches reveal about policy outlook, what the various people whose names have been floated to replace him have to say publicly about how they would pursue policy. I think that that's something the bond market's just going to be really sensitive to. So I'll have to keep an eye on that pretty closely, because we're going to get a slew of speeches before the next meeting, and we'll get a lot of commentary on the talk shows about the Fed right now. So always an important topic for the bond market and one that really resonates with a lot of long-term investors in particular. So along with all the data, I think that's going to be really important.

So that's it for us this week. Thanks for listening. You can always keep up with us in real time on social media. We both post regularly on X and LinkedIn. I'm @KathyJones, that's Kathy with a K on X and LinkedIn.

LIZ ANN: And I'm @LizAnnSonders, only on X and LinkedIn, not on any other platform. Please be wary of imposters. And you can read all of our written reports, they include lots of charts and graphs as do our postings on social media and the written reports you can find at Schwab.com slash learn. And as we always say each week, if you've enjoyed the show, we'd be really grateful if you'd leave us a review on Apple Podcasts or rating on Spotify or feedback wherever you listen or tell a friend about the show. And we will be back next week.

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