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Fed-induced recession ‘is not the base case, but you can’t rule it out,' strategist says

Charles Schwab Chief Fixed Income Strategist Kathy Jones joins Yahoo Finance Live to discuss inflation, slowing global growth, and the Fed's delicate balancing act when it comes to raising interest rates.

Video Transcript

ALEXIS CHRISTOFOROUS: I want to stick with the markets now and actually shine a spotlight on the bond market. And for that, we're going to bring in Kathy Jones, Charles Schwab chief fixed income strategist. Kathy, good to see you again. I'm wondering if you could explain for us, read the tea leaves, and tell us what the bond market is telegraphing in terms of what the market expectations are with regards to the Federal Reserve and its path forward.

KATHY JONES: Well, Alexis, you know, we're seeing a flattening yield curve. And so what it's telling us is that the Fed seems determined to raise short-term interest rates in order to fight inflation. We heard that from Jay Powell very explicitly over the last couple of days in his congressional testimony. And what the bond market is interpreting, that is, there's a risk of recession, or certainly, a big slowdown, down the road. So long-term yields really haven't budged very much. Short-term yields would come up. That flattening yield curve is telling us the market is more concerned about slowing growth than it is about current inflation.

ALEXIS CHRISTOFOROUS: So will stagflation become sort of the new buzzword for Wall Street, that environment of higher rates, but slowing growth? And is the fear that stagflation would be the thing to tip us into recession?

KATHY JONES: Well, I would take a little bit of exception to the term stagflation just because the economy is hardly stagnant. It's still growing at a pretty healthy pace. So it's more that it will slow from the very fast pace that it has been growing over the last couple of quarters into a more moderate pace. But we still have a pretty healthy outlook. But I do think the worry is that as we get into further and further tightening by the Fed and then complicated by the Ukraine war and what that may mean for the supply and demand dynamic in the economy, there is a worry that if not stagflation, certainly recession down the road is the big worry.

ALEXIS CHRISTOFOROUS: How-- do you think that that worry is really founded? I mean, I understand that that flattening of the yield curve, you know, history has shown that it is usually followed by a recession. Doesn't mean it's guaranteed. So what are your thoughts on that? Because so far, consumers seem to be hanging in there, even with inflation at a 40-year high.

KATHY JONES: Yeah, it wouldn't be our base case forecast by any means. I think the dynamic, though, is really what the Fed does and how quickly they tighten. Do they use the balance sheet to drain liquidity very rapidly? Are they so concerned about near-term inflation or inflation this year that they raise rates so aggressively that it does feed on itself and start to reduce business investment, consumer spending? At a time when the global economy is looking for liquidity, the Fed is tightening. So it's a pretty complicated situation. It's not our base case that we could get a recession, but you can't rule it out.

ALEXIS CHRISTOFOROUS: How much has the war in Ukraine really changed the economic path forward for the Federal Reserve? I mean, to most of us, it seems like not much since we have Fed Powell-- Fed chief Powell saying that these interest rate hikes, at least in the short-term, are very much going to happen.

KATHY JONES: Yeah, they seem-- the Fed seems very determined to move ahead with its plan of steady rate hikes. We've always been under the consensus estimate for the number of rate hikes the Fed would be able to pull off this year because we do see somewhat slower growth down the road. And depending on what oil prices do, which is a real wildcard here, but we could see some easing and inflation pressures later in the year as well.

But they seem very determined to follow that path now. We've seen pivots before, so they're going to be data dependent like the rest of us. I would say it's a very uncertain outlook right now. The war in Ukraine has really created an almost unprecedented set of conditions that the central banks globally have to deal with. The sanctions are so extensive and have become so widespread, even by private industry, that this is causing disruptions to the supply-demand balance globally. And I just don't think we've been here before. And to have major central banks tightening into this is a situation that is fraught with a lot of difficulty and pretty risky.

ALEXIS CHRISTOFOROUS: You know, we are seeing investors chase yield, as they do. And it's not exactly easy to find it, at least in the bond market right now. And I'm wondering where you are seeing the most appetite at the moment. Are investors willing to take on a little more risk? And are they investing heavily into junk bonds at the moment?

KATHY JONES: We are still seeing a pretty healthy high yield market. There still seems to be interest because the yields are pretty attractive. The spread versus treasuries is pretty low. But on an absolute basis, there seems to be a lot of confidence in the high yield market. So it has held up really pretty well, considering the level of volatility in the market. High yield's doing OK. We're also seeing interest in bank loans. Those are shorter term, still high yield and quality, but shorter term floating rate instruments. And there's a great deal of interest in those as well.

ALEXIS CHRISTOFOROUS: And really quickly, just wondering if Muni bonds are coming back into favor because we heard President Biden at the State of the Union this week talking about infrastructure, how there were something like 4,000 new contracts already in place. And I'm wondering if, you know, the Muni bond market is starting to pick up as a result.

KATHY JONES: Yeah, Muni bond valuations have improved a lot. Maybe a couple of months ago, they were just so overbought and overdone for short-term munis as people anticipated tax increases that the valuations weren't that good. But the credit outlook is very positive. State and local governments have really benefited from the rebound in the economy, increasing tax revenue, some of the pandemic payments, and now we'll get some infrastructure projects as well. So we do expect a pretty healthy Muni market this year. And it is attracting a lot of buyers who, you know, are looking for that sort of higher credit quality, lower volatility investment in this very volatile environment.

ALEXIS CHRISTOFOROUS: Yeah, tough to find that combination. All right, Kathy Jones, chief fixed income strategist at Charles Schwab, good to see--