The Fed could 'overestimate the strength of the economy' with too many rate hikes, Kathy Jones says

Charles Schwab Chief Fixed Income Strategist Kathy Jones, joins Yahoo Finance Live to discuss Fed monetary policy and the market as rate hikes are expected.

Video transcript

KARINA MITCHELL: And I want to bring in our next guest, Kathy Jones, Charles Schwab chief fixed income strategist. Kathy, thanks so much for being here. And bring it back to market action today. And I just want to get your reaction to the latest core PCE numbers that we got today, 4.9%, the highest rate since 1983. And then wondering, how many rate hikes do you think that come this year? The markets now seem to be pricing in that we'll see five of them.

KATHY JONES: Yeah, so the core PCE was high. It was, though, pretty much in line with expectations. We've known that these inflation readings would be high over the next quarter or two. So it didn't really surprise anyone. I think actually we might see a little bit of a deceleration going in the next couple of months. We're starting to see the personal spending tail off a bit. And that could be a harbinger of consumers really just resisting price increases.

We've actually only penciled in three rate hikes for this year. I know that that's well now below where the bidding war is for how many rate hikes the Fed might do. But our view is that it's really premature to talk about much more than three until we know what the plan is for the Fed to use its balance sheet to tighten policy.

Expect that to kick in, in the middle of the year. We hope to get some clarity on it at the next Fed meeting. And then we can balance out how many rate hikes might be needed vis a vis how much the balance sheet could be drawn down as a way of tightening policy. So we think some of the estimates are just well ahead of reality at this stage of the game.

KARINA MITCHELL: Well, Kathy, what signal do you think the bond market is sending to us on the front? And the two-year is higher. The curve is flattening. What do you make of it?

KATHY JONES: Yeah, you know, you typically see that when the Fed is in hiking mode. Now, they haven't started hiking, but they've certainly told us they're going to. And that typically happens. You start to see short-term rates will move up to adjust to the expectations of tighter policy. And then long-term rates start to level off because the expectation is that as the Fed tightens, they'll slow down the economy, and they'll pull inflation down.

And I would note that despite the current high inflation readings, the inflation expectations data that we're getting embedded in the markets not risen all that much. So the long-term expectations, they're still anchored around 2 and 1/2% or so. So it isn't as if the market has lost faith in the Fed's ability to bring down inflation longer term. I think that's reflected in the yield curve.

KARINA MITCHELL: And then, low rates right now, tight spreads. How attractive is the fixed income segment right now? And investors in equities are getting hammered. Is this a time to sort of-- you know, there is no alternative. Maybe fixed income is the alternative right now.

KATHY JONES: Yeah, maybe there is an alternative finally. So as the Fed raises rates, we think that there's opportunities in various parts of the yield curve. For people who have just been sitting in cash, they'll be able to get 1% to 2% in a very short-term Treasury perhaps. Now that may not sound great, but if you've been sitting in cash and getting 0, that's an alternative.

For people who have a longer term perspective and are buy and hold investors, we'd actually start moving out a little bit in terms of intermediate or longer term yields. Again, they're still relatively low compared to history, but they're much better than they were a year or so ago. And if the Fed is successful in tightening policy enough to quell inflation, we're not going to see long-term yields surge from these levels. They could still move up, but we would start capturing that by kind of rolling in gradually into longer duration bonds at this stage of the game.

KARINA MITCHELL: And then when do you see inflation sort of peaking and then starting to moderate? And then how big a fear is the Fed gets it wrong on inflation?

KATHY JONES: Well, those are huge questions. We do see the inflation pressures starting to ease, so probably late second quarter, second half of the year. You know, one thing we'll be watching is the housing market because that's really been on fire, and that's lifting-- that's likely to lift the rent component of inflation. So as the Fed raises rates, and mortgage rates go up, housing prices may start to correct a little bit. Certainly, the housing market would slow down a bit. And that could take some of the pressure off of those rents and that portion of CPI.

So we're looking towards the second quarter, third quarter, to see the inflation numbers come down a bit. You know, and then longer term, it really-- will the Fed get it right or not? They have a history of aiming for a soft landing and ending up with a hard landing. No central bank wants to kill the economy in order to bring inflation down. But right now, I think there is a risk that they move too far too fast and that-- and overestimate the strength of the economy and the run in inflation that we're seeing. I think there's probably a greater risk than they move too slowly and allow inflation to get even further ahead of them.

KARINA MITCHELL: And then, Kathy, what's the wild card, really quickly, in all of this? Because we heard very little concrete about QT from Powell.

KATHY JONES: Yeah, I think that for me, that's just the most interesting part. So if the Fed decides to use the balance sheet rather aggressively to bring down rates, meaning let the size of it come down. It could come down pretty fast. They have a lot of short maturity T-bills that they could allow to mature and run off.

We could get, you know, easily $500 billion, up to a trillion, off of the balance sheet, very quickly. That's the equivalent of a couple of rate hikes. So I think that's where the question mark is. If the Fed decides to be aggressive or even outright sales of, say, mortgage-backed securities, that could have a pretty strong dampening effect on inflation and on the markets.