Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Yield Curve Uninversion
Transcript
- Lucas: So the yield curve just did something it hasn't done in over two years — it started to uninvert. And that's a big deal for anyone watching the Fed. Luna: You mean the gap between the two-year and the ten-year Treasury? I saw the ten-year at 4.43 percent and the two-year at 3.63 percent — that spread was positive for the first time in a long time. Lucas: Right. For context, the two-year yield has been above the ten-year yield since July 2022. That's one of the longest inversion stretches on record, and it had everyone waiting for the recession that never quite showed up. But now the ten-year is yielding about 80 basis points more than the two-year, which is a completely normal shape for the curve. Luna: I know historically, uninversions often happen right before a recession hits. But we're sitting here in mid-2026 with the S&P 500 above 7,500 and the economy adding jobs — so is this time different? Lucas: That's exactly the question the Fed is wrestling with. And the answer is going to depend on why the curve normalized. Was it because markets started pricing in rate cuts — which pulled the two-year down — or because longer-term inflation expectations started creeping up again? The Fed is watching those breakeven rates closely. The ten-year breakeven is currently at 2.29 percent, down a bit from a few weeks ago, so that's not screaming runaway expectations. Luna: But the two-year came down a lot — from around 4 percent in April to 3.63 now. That feels like markets betting on the Fed cutting rates later this year. Lucas: Exactly. And you can see that in the fed funds futures market. The effective fed funds rate is at 3.63 percent right now, so there's basically no premium for holding two-year debt. The market is fully pricing in at least a quarter-point cut by September. The question is whether the Fed will deliver it. Luna: I mean, the last CPI print showed headline inflation at 4.4 percent year-over-year, and core at 4.6. That's still well above the target. How can the Fed justify cutting rates with those numbers? Lucas: That's the tension. But remember, the Fed looks at PCE, not CPI. The latest PCE reading for April was 2.9 percent on headline and 2.8 on core. That's closer — still above target, but moving in the right direction. And if you look at the monthly momentum, some of the stickiness is coming from shelter and services, which lag by nature. The Fed might see enough progress to start normalizing policy gradually. Luna: So the uninversion could be the market's way of saying the tightening cycle is over. But what does that mean for the broader economy — for banks, for borrowers? Lucas: For banks, an uninverted curve is actually good news. They borrow short-term and lend long-term. When the curve is inverted, they get squeezed — their net interest margin shrinks. That was a big story in 2023 with the regional banking stress. Now that the curve is positively sloped, banks can lend more profitably. That should support credit creation, which is a positive for growth. Luna: But if the economy is already strong — S&P near all-time highs, unemployment low — does the Fed really want to stimulate more by cutting rates? That might reignite inflation. Lucas: That's the risk. But the alternative is that the economy slows more than expected. We've seen some data points — the UK economy shrank in April, there's geopolitical uncertainty around Iran and shipping lanes. If that starts to infect the U.S. consumer, the fed might need to cut not because inflation is beaten, but because growth is stalling. The uninversion could be the canary in the coal mine. Luna: Looking at the data, the ten-year yield is at 4.43 percent. That's still high relative to the last decade. So even though the curve normalized, the level of rates is restrictive. That suggests the economy is absorbing high rates pretty well so far. Lucas: It does. And that gets to the neutral rate discussion. The Fed's estimate of r-star — the neutral rate — has been creeping up. Some economists think it's now closer to 3 percent, which is well above the pre-pandemic estimate. If the neutral rate is higher, then the current fed funds rate of 3.63 isn't as restrictive as it looks. That would explain why the economy hasn't cracked yet. Luna: That's a huge shift. If the neutral rate is really 3 percent, then the Fed might not need to cut as much as the market expects. They could hold here for a while. Lucas: Right. And that might be what they signal at the next FOMC meeting. They'll have the updated dot plot, and a big question is where they see the terminal rate. If they keep it at 3.5 or higher, that would push back against the market's aggressive rate cut expectations. The uninversion might be a false signal if the Fed stays hawkish. Luna: So the uninversion is happening, but it's not necessarily a green light for the economy. It could be a warning about the lag effects of tightening. Lucas: Exactly. Historically, the average lag between the start of a tightening cycle and the onset of a recession is about two years. We're roughly two years from the first rate hike in early 2024. So if a recession does come, it could hit later this year or early next year. The uninversion in the middle of that timeline is consistent with what we saw before previous downturns. Luna: Let's talk about the short-end a bit more. The two-year yield at 3.63 is basically at the fed funds rate. That suggests the market thinks the Fed will cut at least once. But if the Fed doesn't cut, the two-year could spike again, leading to a new inversion. Lucas: That's a real risk. And it would be a mess for the bond market. The curve has been inverted for so long that some traders have built strategies around it. A re-inversion would cause another wave of adjustments. But I think the more likely path is that the Fed cuts cautiously — maybe one quarter-point this year — and then holds to see how the economy evolves. Luna: That would keep the curve positively sloped but flat. Two-year yields might stay near 3.5, ten-year near 4.3, so a spread of 80 basis points. That's not steep, but it's healthy. Lucas: And that's probably the best case for the economy — gradual normalization without a hard landing. The Fed can claim victory on inflation without breaking the labor market. The uninversion becomes a sign of successful policy transmission rather than a recession omen. Luna: But if the economy does slow sharply — if the geopolitical risks materialize or if the consumer finally runs out of pandemic savings — then the uninversion will look like the classic pre-recession signal. The next few months will be telling. Lucas: They really will. That's what makes this such a pivotal moment for the Fed. They're in a data-dependent mode, and the data is sending mixed signals. The yield curve is just one piece of the puzzle, but it's an important one because it reflects the market's collective view on the path of rates and growth. Luna: So as a listener, what should I watch for? The next CPI report? The FOMC statement? Lucas: Watch the two-year yield. If it stays steady or falls further as the ten-year holds, the market is confident in cuts. If it starts to rise again, the market is questioning that narrative. Also watch the Fed's language on the neutral rate. If they start talking about r-star being higher, that's a signal they're comfortable holding rates higher for longer. Luna: And the data — PCE for May comes out in a few weeks. If that shows continued progress on core inflation, it gives the Fed cover to ease. Lucas: Exactly. So bottom line: the uninversion is a major milestone, but it's not the end of the story. It's the beginning of a new chapter where the Fed has to decide whether to follow the market's lead or hold the line. And that decision will shape everything from mortgage rates to stock prices to hiring. Luna: I think that's a great note to wrap on. A nice, grounded look at the curve and what it means for the Fed. Lucas: Thanks for listening. If this kind of analysis helps you make sense of the economy, consider supporting the show at buy me a coffee dot com slash fexingo. It keeps us ad-free and focused on the data. We'll be back tomorrow with more.