COLLIN MARTIN: I'm Collin Martin.

KEVIN GORDON: And I'm Kevin Gordon.

COLLIN: 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.

COLLIN: Well, hi, Kevin. This is usually where I would say "Hi, Liz Ann," but she's on a well-deserved vacation right now, so we have you filling in for her this week. So thank you so much for joining.

KEVIN: Hey, Collin, nice to be here. I believe this is our first time doing this together, just you and me. I've been a guest on this before, but it has not been you and me. So I'm excited to be here. Thanks for having me.

COLLIN: Yeah, I was thinking the same thing. I know you've been on this podcast a number of times. So if you're a repeat listener, Kevin is no stranger here. He is Schwab's head of macro research and strategy. And Kevin and I sit just a few doors down from each other and have these discussions off mic almost every day. So it's good that we're having it on mic to give you all a look into kind of how we work together and the conversations we're having.

So Kevin, let's start with you. And you know, since you cover everything macro, let let's focus on the U.S. economy and the overall health of the U.S. economy and something you mentioned recently, when we look at the economy, and we think about good news, and what does that mean? And you said something like "Good news can be bad news." What do you mean by that?

KEVIN: Yeah, so I think mostly in that … in the context of the labor market for that particular message. So the whole idea is that right now, of course, everybody is probably quite aware that inflation is more of an issue as opposed to the labor market, especially if we're thinking about things in the context of how the Fed views things. And the whole idea around good economic news being bad market news, at least for the stock market, and it could be the same case for the bond market, but I'll let you weigh in on that. But the whole idea is that … let's say you get a really strong jobs report, and there's a downtick in the unemployment rate, and you see maybe some strength in wage growth that wasn't expected to be there. This is all hypothetical, but if that were the case, historically, in the past couple of years, that has meant that the market starts to price in maybe some Fed rate hikes, some tightening in monetary policy, and then that's met with a negative reaction from the stock market.

And if you were to look at this almost visually or think about it as a picture, it has been very interesting and a little unique relative to history, where in the past several years, the S&P 500® and the U.S. unemployment rate have actually been kind of moving up and down together. So it's not perfect. It's not a perfect relationship, but the general trend has been when the unemployment rate has been going up, the S&P 500 has been doing better, and then vice versa. So I think it's a way to think about the fact that when you do have some of that release in the labor market where, you know, as of a couple of years ago, unemployment was rising, you were working out some of that sort of excess demand and labor demand, wage growth was falling. So it was sort of disinflationary for the Fed at least, and that was being looked at favorably from the stock market's perspective.

So it's not a bad thing. I mean we always want good economic news. but it's just sometimes in these periods when inflation is more of the focus and not necessarily growth, that's when you get into some of these, you know, I call them these little rupture periods where markets can at least react negatively, maybe in the short term, more in the short term as opposed to the long term. Because I'm a big believer, and it is true that in the long term you do want good economic data, and you want the fundamentals to be strong because ultimately that's going to support risk assets.

COLLIN: Well, I don't want to pivot to the Fed just yet, but if we want to talk just about the general level of interest rates and bond yields, they all work together. You know, so far, you know, the stock market, which we know is not the economy, but the stock market's doing pretty well. And interest rates are up. So I think that that's probably a good sign.

KEVIN: And I what I find really interesting is if you were to ask an equity strategist, or maybe tell an equity strategist, a couple of years ago, and if you came from the future, and you said, "Hey, the 10-year yield is going to be at 4.6% still. It's going to be in this tight range, and Russell 2000 Value is going to be outperforming the Nasdaq 100." I think nobody would have believed you. But yet here we are with small caps doing well, finally catching a catching a bid. And admittedly, I'll be the first to admit that's a sort of cherry-picked data point that I'm looking at, but it's interesting in the context of rates that are still high. But I think it shows you that as long as the economy is growing, and you are seeing broad swaths of the economy growing, not everything is even. We still have a little bit of a split where business investment is favored more than consumption, as an example.

But if you do look at the breadth of economic activity, which has really started to sort of pick up this year in the past six months, that is one of the reasons that I think you're seeing an area like small caps do relatively well. So yes, I think to your point, it it's not necessarily a level of interest rates that will completely derail a bull market. Oftentimes it's the speed of the interest rate increase or decrease that really is the determining factor. And I think we're sort of living that real time, living that truth.

COLLIN: Yeah. Absolutely. And we're still kind of figuring out what the ultimate path of interest rates will be, especially short-term interest rates, because there's a lot of uncertainty around the Fed right now. And figure that's a good way … let's pivot to the Fed real quickly. It always makes headlines, and I always like to kind of temper expectations a little bit, because the Federal Reserve, it influences one rate, the fed funds rate, which can have a direct impact on certain bond yields, very short-term yields like Treasury bills or CD rates. And then it has more of an indirect impact on other parts of the bond market. And we never want what the Fed may or may not do over the next few months or quarters to necessarily be the primary driver of your decisions as it relates to bond investing today.

But that being said, we're still going to talk about it because everyone likes talking about the Fed. And last week we got a Federal Open Market Committee meeting where the Fed held rates steady, but there were noticeably three dissents from three voters who preferred to hike rates. So we're seeing this pivot, which we saw initially in June, of moving from what could arguably be a dovish committee, which meant leaning more towards the path of rate cuts, to a more hawkish committee. So in June they pivoted to a little bit more of a hawkish stance where rate hikes might be more likely. And then last week we saw that there's actually three voters who said, "Yes, I think we should actually be raising rates right now." We didn't get that from new Fed Chair Kevin Warsh. I would say we didn't really get much from Kevin Warsh. He doesn't say much. And that's been a big topic.

So let me talk about that a little bit, Kevin. And then I want to hear your thoughts. The big buzzwords we keep hearing are, you know, "forward guidance" and "reaction function." So when I think about forward guidance, that's when we listen to the Fed either as a whole or the committee members kind of telling us what they think will happen. And Warsh has been very clear he doesn't want to do that. He doesn't want to be telegraphing what the Fed may or may not do. I think that's fine.

I'm not too concerned with that, but we want to know what they're looking at and what might drive their decisions. And that's where we get to that idea of the reaction function. If the economy does X, Y, or Z, what will the Fed or what should the Fed do? And Kevin Warsh isn't really giving us that, either. He's not really telling us how he views the level of restriction right now. He doesn't think if rates are too high, too low, or right on target. He hasn't told us what he would need to see to drive a potential decision down the road.

But the good news is it's a committee. And it's not just Kevin Warsh. So while there's been a lot of headlines and concerns about Kevin Warsh not being very clear about what he wants to do, a lot of other committee members have. And you know, we know from the three dissenters what they're looking at. New York Fed President John Williams has kind of laid out what he thinks needs to happen in terms of the inflation path.

We got a blog post from the Philadelphia Fed president about what she's looking at and that she voted to hold rates steady, but she kind of laid out things that could happen that could maybe result in a hike. So we're getting this from a lot of other people. So even though everyone's kind of homing in on the lack of communication by Kevin Warsh, we're getting it from others. So what are your thoughts on that?

KEVIN: Well, I'm so glad that you point out the distinction between forward guidance and the reaction function, because I really don't think that a lot of this conversation or the debate is about forward guidance. I don't think that's where the issue is is forward guidance. I think it is to what you talked about. It is the reaction function, particularly on the part of Warsh, because we don't really know his. And I … in the … when I was watching the press conference and thinking about it afterwards and throughout the weekend, because that's what I do in my free time, I was sort of thinking about back to last year when Governor Chris Waller was going through … and he was a very, you know, he's been a vocal voice on the committee. He is very widely followed, you know, very much listened to.

And I think that I kind of use him as sort of as a poster child example of last fall when the labor market was really struggling, we were seeing non-farm payroll growth on, you know, on an average, three-month average basis basically slip down to nothing. And that was giving us a lot of giving a lot of economists sort of this raised antenna and yellow flag of "OK, is the labor market about to go into a recessionary cycle?" and his focus was squarely on labor. And that was one of the reasons he was voting for policy to be, you know, easier and more dovish, and he was voting for rate cuts. Vice versa, now he has been talking about why he has shifted towards focusing on inflation, and he's given his reasons for that. He's talked a lot about the fact that the Fed cannot just stand there and watch inflation melt because it doesn't work that way. So I think that's a clear example of his not giving necessarily forward guidance. It's not that he was telling us, you know, every single time, hey, this is what my vote is going to be next month. But he's telling us what he's watching for.

Most recently he said if we get, you know, a string of hot inflation prints, then I'm going to vote to make policy more restrictive. And I know you've talked about this in terms of the June CPI report in particular, the Consumer Price Index report we got for June, which was flat for core and then for headline, which includes everything, so the impacts from energy, that declined pretty significantly. That probably bought the Fed a little bit of time in in terms of the majority of members holding off on hiking rates. But that was to me a clear example where Chris Waller probably saw that and said, "Well, this was a pretty good report. I do have a little bit of time to adjust my, you know, my thinking around inflation, and then let's see what the next couple of months come in at."

So I sort of view that evolution in his thinking as a way to sort of see the reaction function in real time and how it can work. Not necessarily this … what people call this sort of market hand-holding that is forward guidance. I just don't think that that's really the debate of the discussion right now. But to your point, and I'm glad you pointed it out, the whole idea of this being a committee, we are getting comments from voters. So it's not it's not as if we're completely in the dark. You're hearing from people like Neel Kashkari from the Minneapolis Fed talking about, "Hey, we're dealing with successive supply shocks. Normally we would look through that, but this time we probably have to adjust policy in an incremental way in order to avoid having to hike rates aggressively down the road." So I think that's become a really important part of the discussion.

But I want to toss it back to you in terms of, you know, I think probably the most noteworthy part of the FOMC day last week was the reaction from markets. And it was really this sort of cross-asset response of shorter-term yields moving, you know, down, longer-term yields moving up, the stock market had a negative reaction, the S&P 500 fell, the dollar also fell. So when you look at that aggregate, I guess, vote from the market, it's not the best in terms of how the market sort of views inflation-fighting credibility for the Fed.

I will say that's just one day, so I'm not extrapolating that. But if that were to continue to be the move, especially in the bond market, how do you think about that moving forward, especially what it means for the longer end, for the 10-year or even for the 30-year, for instance.

COLLIN: So you mentioned credibility there, and I think that's the key point. And what we saw, you know, first going back to the June FOMC meeting, which was Warsh's first as chair, he made it very clear, crystal clear, that the committee was committed to bringing inflation down and that sent a message to the market that they were ready to act. And then fast forward to just last week, you know, they didn't act, which I think was as expected. As you mentioned with the CPI prints, the cool June data suggested the Fed could wait and see.

But Warsh didn't tell us much, and he referenced the market reaction and that rates had risen to show, "Well, OK, we didn't raise rates. We, the Fed, didn't raise rates, but yields have increased and that should tighten financial conditions." But I think the question is, "Well, you need to follow through if you truly want to fight inflation." You know, the markets can adjust if they think you're going to hike rates. If you don't, when the data suggests you should, and we're not there yet, but if inflation continues to pick up and the labor market remains resilient, a hike would certainly become more likely. If the Fed doesn't follow through, then credibility would be questioned. So right now I don't think there's a credibility issue. It's too early, and the data in June suggested they didn't need to hike.

But what we're seeing with bond yields and especially long bond yields is, well, if you're not going to raise rates to squash inflation, and inflation then continues to rise, and if inflation expectations become unanchored, which they're not yet, but if they do, that suggests, you know, higher long-term yields. So interesting market reaction. We've seen it come down a little bit since then. There there's a lot of moving parts when we talk about long-term Treasury yields. And we talked about this earlier, Kevin, where the Fed can directly influence certain yields, can't directly influence other yields. When we think about the 10- or 30-year Treasury, it has to do with, you know, expectations for Fed policy over the next 10 to 30 years.

It has to do with inflation expectations. It has to do with fiscal policy. If we're worried about the trajectory of our debt, are investors going to demand higher yields for that risk? So that's what's driving that. And we think long-term yields are probably going to remain elevated. To tie this into a kind of guidance, what we're suggesting our clients do, even though long-term yields have increased. If we look at the 10-year Treasury yield, it's around 4.6% or so today. That's relatively attractive compared to the last 15, 16, 17 years, but we don't think investors are going to miss the opportunity to earn that sort of yield. And we think there's risks that they do move higher, given a potential higher-for-longer Fed policy,

given sticky inflation, uncertain inflation outlook. So we don't think investors will miss the opportunity. We suggest, you know, maybe more short- and intermediate-term maturities.

One question back to you. I don't want to make this too Fed heavy. although it already is. Can you talk about the potential impact of, say, the stock market to the Fed? Let's say they did hike one or two more times to just, you know, maybe undo those so-called insurance cuts from last year versus more than just one or two rate hikes, a rate-hiking cycle. What sort of impact might that have on the markets?

KEVIN: Yeah, this is a hot topic because you'll often hear the argument that, "Well, as soon as the Fed starts tightening policy, that's just going to kill the bull market." And it goes back to that old adage of "Bull markets don't die of old age. They, you know, they're often ended by the Fed." And to some extent that is true, that's happened before, but the whole, I think, caveat that you mentioned with if it's a couple of rate hikes, that's actually really important and very central to the analysis.

Because when you go back in history, and you look at what is called a non-cycle. So a non-cycle for the Fed in equity market terms would be maybe one or two rate hikes, you know, spaced out a couple of, you know, between a couple of meetings, doesn't necessarily have to happen consecutively. But we've had four of those in history. And actually, you know, when you look at the equity market's reaction, in particular the S&P 500, the reaction at first, there's typically a volatility event, you know, the market maybe not reacting favorably to it, especially if it's a surprise hike, but in the long run, you know, call it six to 12 months, maybe in the medium term, on average the S&P 500 is up in that period.

Now, Liz Ann and I are big fans of saying "Analysis of an average leads to average analysis." So you never want to put too much weight on that average. Plus the last time that we had a non-cycle was 1997. Things have clearly changed since 1997. So I think that we should also be taking this with a bit of a grain of salt. But I think that broadly this just comes back to economic fundamentals. And as much as I think when you were tying this to the fixed income call, if you tie this to the growth call for the economy, I mean, we really don't see any signs of a significant slowdown in U.S. growth.

Could we moderate a bit? Yes. Do I think 6.5% nominal gross-domestic-product growth is the new norm? Probably not. That's where we're at right, you know, as of the second quarter. You know, nominal GDP is in this accelerating trend. You probably have some room for that to move a bit lower, but you still have an economy, in inflation adjusted terms, that is growing. You still have a labor market that has remained relatively resilient. So even if the Fed were hiking into that, and it wasn't an aggressive hiking cycle, and they were not committing to a series of hikes, because I think that would be a very, very dramatic hawkish pivot at this point, then I think that it's not necessarily a bad scenario for the stock market.

So I think you have to keep that in mind. The background conditions of the economy remain, you know, pretty favorable. We're still, of course, in a little bit of a … maybe not totally synchronous and harmonious economic cycle where, yes, the consumer has taken a bit of a backseat over the past year, year and a half. But some of that has started to heal, and you're starting to see some of those gaps close. It's not going to be perfect. It's not going to be linear, but I do think that that the economic tailwinds are still fairly strong. So that, to me, at the end of the day, keeps the equity market going, not without, you know, significant disruptions at times as we've sort of learned over the past couple of months.

You have had some significant drawdowns, especially in semiconductors and the memory names and the hyperscalers. But a lot of that has been offset by the other parts of the market that have held up and done relatively well. So if anything, I think it of course argues to be, you know, in favor of diversification, but I think realizing and understanding that economic fundamentals at the end of the day continue to look supportive of the equity market, I think that's what's going to matter most.

COLLIN: I want to pivot just real quickly. We focused a lot on the Fed, but a big headline over the past week has been the Japanese yen and the intervention from both the U.S. and Japan. I'll pull a Seinfeld quote. I won't do his voice. I'll just say, "What's the deal with that?" What's going on with yen intervention?

KEVIN: Well yeah, I mean so it's been 28 years since you had a coordinated effort from both the Treasury and the Ministry of Finance in Japan. And yeah, it was a pretty significant intervention. And you could look at a chart of the yen and see how weak it's gotten, especially relative to the dollar, probably I think the most displayed chart that I see, you know, when I go on financial Twitter or LinkedIn. But it's interesting because it's not as if it was this one big moment that the yen had weakened and then that's when the Treasury decided to intervene. It has been gradually weakening over time and at many times over the past couple of years has hit, you know, most multi-decade lows relative to the dollar.

So from that standpoint, it is probably understandable to see why there was some sort of coordination to intervene and maybe stem some of the bleeding there. But what I find really interesting is that, you know, if you go back in history, and you look at the last time the Treasury did this was 1998. And there was a little bit of a of a rally for the yen. So it did strengthen after that, which is to be expected. But in the following weeks it actually retouched the lows and actually broke through the lows in the prior week level. What was interesting was that 1998, of course a very tumultuous year for the global economy because you had the Russian debt default by the summer and late summer of that year. But then you also had the collapse of Long-Term Capital Management. And those events are actually what ultimately drove the yen to strengthen.

So it's interesting, and of course, you never want to pick one period in history and use that as your analog, because of, you know, like I said before, things have changed in the global economy. We face different risks than we did in the late '90s. But I do find it interesting that when you go back in that period, it wasn't necessarily … you couldn't necessarily point to intervention alone from Japan and the U.S. as the thing that ultimately saved the yen. It's a little bit hard to do that when you had these two, you know, massive global events, one of which was a huge debt default from a big country. So I think it's historically the nerd in me is very interested in sort of looking at that period and seeing what could be different this time, but also understanding that there are limits, you know, to what institutions can do versus what markets will ultimately do. We've seen that happen before, but it does also call into question this whole idea of the yen carry trade, which we get asked about a ton.

So I'm curious your thoughts on that and ultimately what this means, especially for the Treasury market, because a lot of the discussion, especially with what we were hearing from the Treasury secretary, was it, you know, relating this sort of yen intervention back to what it means for Treasury yields here in the United States.

COLLIN: Yeah, there's a lot going on with this. So one, on the yen carry trade, so for those unfamiliar, you know, institutional investors will borrow in the Japanese markets in yen because of their low borrowing costs and then invest in higher-yielding investments, more attractive investments elsewhere. When the currency weakens, that's a good thing. You're borrowing in something that then you can repay at a cheaper price. When the currency strengthens, like which is what we saw over the past few days, that can hurt you. So that's a risk right there.

How long this goes, I think is a question. I'm with you, Kevin, where, you know, intervention like this I think can only last so long. I think policies need to be the ultimate solution. You mentioned the rationale for the U.S. aid. I think there's a few things, but there are some thoughts out there that the U.S. helped because Japan is the largest holder of U.S. Treasuries. And if they need to defend their currency themselves, do they need to then sell Treasuries to finance that, you know, to sell that and then use that money to defend their own currency?

So there's this idea that our yields have risen enough already, and if the largest holder starts selling them, that could pull yields up a little bit. I think it's too early to tell what the ultimate motivation is, but it's something to consider when we think about the direction of long-term yields. Supply and demand matters. And when our, you know, deficit situation doesn't appear to be improving from a long-term outlook standpoint, it's going to mean more and more debt. We need to find more and more buyers, not just domestically but abroad.

But I do think a lot of it comes to policies. And when you look at, you know, the Bank of Japan, their rate is still very, very low. They've been hiking for the past two years, but at a snail's pace. And when you look at interest-rate differentials, you can get much higher yields in short-term, you know, U.S. investments or European investments compared to Japan. And when you don't have attractive short-term interest rates, it's hard to attract capital. I think that's probably the key driver there. So something to keep an eye on. It'll be interesting to see if the intervention, the messaging, worked or, to your point, Kevin, if we see that kind of reverse and, you know, see the yen weaken a little bit down the road.

Kevin, let's look ahead a little bit. You talked about the labor market. We have a jobs report coming out this week, so after we're recording. Along with that, what else is on your radar for the next week? What should investors be watching?

KEVIN: Well, in the spirit of keeping this Fed heavy, I am of course watching inflation. So that's going to be to me the biggest release for July, both the Consumer Price Index, but also we get the Producer Price Index. As some listeners will know from either hearing you, me, or Liz Ann over the, you know, past couple of months, Producer Price Index is very key for the Fed's preferred gauge, which is the Personal Consumption Expenditures price index, because you get some components that feed into it, from PPI to PCE.

So that's a big focus for me. But I think also just generally the Fedspeak that we're going to get and what we're going to hear from certain members, even the nonvoters, I think that it's instructive to listen to what they're saying and what these discussions are like around the table when they have these meetings, how they're viewing inflation. And for me, even though labor is not their chief concern right now, I do want to hear more about how they think about the labor market because I still think that some of the hesitancy to hike rates has been not wanting to maybe derail some of the labor recovery that we've seen this year.

So I do want to hear about how they're thinking about, number one, the health of the labor market, but number two, if it is potentially becoming inflationary, or they see that, you know, by the end of the year if there's a forecast for unemployment to move lower. So that's very inflation-centric, but obviously a lot of moving parts with labor and with Fedspeak. But how about you? What are you looking for?

COLLIN: Yeah, you stole my thunder there. I was going to say the Consumer Price Index, the CPI. I think it's very important. And going back to the discussion we had earlier, the soft June prints bought the Fed some time. But we know inflation, you know, is still a concern right now. And I'm in the camp that, you know, any hotter than expected prints we see, whether it's July or August, could get more Fed officials from the hold camp into the hike camp. So the next few inflation readings will be very important.

We also get retail sales next week. Always a reminder, those are nominal. They include price increases. So you want to see, you know, how much of it is price increase versus volumes. And then we get the University of Michigan surveys, gives us an idea of sentiment, but we also get some inflation expectations on a short- and intermediate-term basis with that report.

That is it for this week. As always, thank you for listening. You can always keep up with us in real time on social media. I'm @CollinMartinCS on X and LinkedIn. That's Collin with two L's, and the CS is for Charles Schwab.

KEVIN: And I am @KevRGordon on both X and LinkedIn as well.

COLLIN: And you can find all of our written reports, which tend to include lots of charts, graphs, tables, illustrations, at schwab.com/learn. And be sure to check out Kevin's "Week Ahead" videos on our YouTube channel. You can also find them on Kevin's LinkedIn pages. And I think, Kevin, those come out every Monday morning. Is that right?

KEVIN: Every Monday morning. And I think we've now expanded out to Instagram and TikTok. So it's hard to miss if you're in all those channels and consuming them.

COLLIN: Yeah, we're coming out with all different forms of media, which I think is very exciting. It's always great to consume content not just from reading articles, but podcasts, videos, things like that. If you've enjoyed the show, please consider leaving us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. And of course, please tell a friend or more about the show. And Liz Ann and I will be back with a new episode next week.

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