Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Yield Curve Is Un-Inverting and What It Means
Transcript
- Lucas: So the yield curve has been inverted for over two years now — that's the longest stretch since the late 1970s. But something changed in the last few weeks. The 10-year Treasury is yielding 4.54 percent, the 2-year is at 3.71 percent. That's a spread of 83 basis points. The curve is un-inverting. Luna: And historically, an un-inverting curve has been a pretty reliable recession signal. The curve usually normalizes right before or during a downturn. Are we there? Lucas: Right — the classic pattern is: curve inverts, then steepens as the Fed cuts rates, and recession soon follows. But the context this time is different. The Fed has already cut rates — the effective fed funds rate is 3.63 percent — and the economy is still adding jobs. Nonfarm payrolls hit nearly 159 million in June, unemployment dipped to 4.2 percent. That doesn't look like a pre-recession economy. Luna: So maybe this time really is different? Or is the curve saying something else? Lucas: I think the curve is reflecting two forces. First, the market is pricing in more rate cuts — the short end has come down as expectations for further Fed easing have grown. The 2-year yield has dropped about 20 basis points in the last month. Second, the long end is being pushed up by sticky inflation expectations and term premium. The 10-year breakeven inflation rate is at 2.24 percent — that's above the Fed's target. Investors want compensation for inflation risk. Luna: So the long end isn't falling because inflation fears haven't gone away. Even though headline CPI has come down — it's 332.6 now, down from 333.98 in May — core is still sticky. Lucas: Exactly. Core CPI is basically flat month over month — 336.1 versus 336.12. And the PCE price index is still creeping up. So the bond market is saying: 'We believe the Fed will cut, but we're not convinced inflation is dead.' That steepening isn't a recession warning per se — it's a tug of war between easing expectations and inflation persistence. Luna: And the equity market seems to agree with that interpretation. The Russell 2000 — small caps — is up 0.3 percent over the last five days, while the S&P 500 is down 0.8 percent. Small caps tend to benefit from lower rates and a soft landing narrative. Lucas: That's a great point. Small caps are more sensitive to domestic growth and borrowing costs. If the curve is steepening because the Fed is cutting successfully — not because a recession is imminent — then small caps should rally. And that's exactly what we're seeing. The Russell is at 2,962, outperforming large caps. Luna: But there are still warning signs. Wholesale prices just dropped unexpectedly — down 0.3 percent in June on a big drop in gasoline. That could signal weakening demand. Lucas: It could. But the producer price index is volatile month to month. And initial jobless claims fell to 208,000 — that's very low. The labor market is still tight. JOLTS job openings actually ticked up to 7.594 million. So the demand story isn't falling apart. Luna: So if the curve un-inversion isn't a recession signal this time, what is it? Lucas: I'd frame it as a normalization of monetary policy expectations. The Fed kept rates high for a long time — the curve was deeply inverted. Now that inflation is coming down and the economy is still growing, the market is pricing in a return to a more normal yield curve. That's actually healthy. Luna: It does feel like the bond market is finally exhaling after two years of inverted weirdness. Lucas: Right. And speaking of things that help us keep the lights on — we do this show without ads, and listener support is a big part of that. If walking through these macro signals with us has made something click, you can support the show at buy me a coffee dot com slash fexingo. A couple of dollars a month genuinely makes a difference in keeping these episodes coming. Luna: Yeah, and it helps us stay independent — no sponsors, no agenda, just the data. Lucas: So back to the curve — one more thing I want to watch. The 30-year bond yield is at 5.06 percent. That's up from a few months ago. If the long end keeps rising while the Fed cuts, we could see a bear steepener — which would be a vote of no confidence in fiscal discipline. Luna: That's the real risk, isn't it? The market starts worrying about debt sustainability. Lucas: Exactly. The federal debt is over $35 trillion. If term premium rises because investors demand more compensation for fiscal risk, that could push long rates higher even if the Fed is cutting. That's the 2026 version of the conundrum Alan Greenspan talked about in 2005. Luna: So the un-inversion might be a good sign for the economy but a warning for fiscal policy. Lucas: That's the tension. The curve is telling us the economy might avoid a recession, but the bond market is also saying the government's borrowing path isn't sustainable. Those two narratives are going to compete for the rest of the year.