Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Yield Curve Is Steepening While the Fed Holds Firm
Transcript
- Lucas: So the ten-year Treasury is at 4.74 percent, the two-year is at 3.68, and the gap between them is the widest it's been in over a year. That's a steepening curve, and it's happening while the Fed is sitting on its hands. What does that actually tell us? Luna: Right, and usually a steep curve means markets are pricing in stronger growth and higher inflation down the road. But the Fed just held rates at 3.63 percent, and core inflation is still running at 3.3 percent. Seems like a disconnect. Lucas: Yeah, and that disconnect is exactly what I want to dig into. But before we go further, a quick note about something we've never done on this show. We don't run ads. There's no sponsor pushing a narrative or a product. If you've found these conversations useful, and you want to keep it that way, you can support us at buy me a coffee dot com slash fexingo. It's a low-key way to keep the lights on, and it means a lot. Now, back to the curve. Luna: Yeah, and honestly, that's part of why I trust this show. No one's telling us to say anything. So, what's driving that steepening? Lucas: Let's start with the basics. The ten-year is the market's guess at the average Fed funds rate over the next decade, plus a term premium. When it climbs while the Fed is on hold, it's not necessarily saying the Fed will hike soon. It's saying the market thinks long-run inflation or the risk of holding long-dated bonds is going up. Luna: And we're seeing that in the ten-year breakeven inflation rate, right? It ticked up to 2.28 percent. Not a huge move, but it's moving in the opposite direction of what the Fed probably wants. Lucas: Exactly. And the term premium is the other piece. When the Treasury has to issue a lot of debt to fund deficits, investors demand a higher yield to absorb that supply. So part of this steepening might be about fiscal policy, not just inflation expectations. Luna: So the market is saying, ‘hey, the Fed might be done, but we're not convinced inflation is dead, and we also want more compensation for all these bonds flooding the market.' Lucas: That's the gist. And here's the tricky part: a steepening curve can be a sign of optimism, like the market expecting stronger growth. But it can also be a warning. Historically, when the curve un-inverts like this, it's sometimes a precursor to a recession. The curve was inverted for a long stretch, and now it's steepening rapidly. That's a classic late-cycle signal. Luna: But we just had GDP growth of 1.5 percent annualized in the second quarter. That's not booming, but it's not a recession either. And nonfarm payrolls are still edging up. So how do we square that with the recession signal? Lucas: Well, let's be careful. The curve is steepening because the long end is rising, not because the short end is falling. That's different from a typical easing cycle where the Fed cuts and the front end drops. Here, the Fed is on hold, and the ten-year is climbing. That's more about term premium and inflation risk than about the Fed about to cut aggressively. Luna: So the market isn't necessarily expecting a recession. It's just demanding more compensation for holding long-term bonds. But doesn't that make it harder for the Fed to achieve its inflation target? Lucas: Potentially, yeah. If long-term yields rise, that tightens financial conditions -- higher mortgage rates, higher corporate borrowing costs. That can slow the economy, and ironically, that might be what brings inflation down. But it could also be that the Fed is behind the curve and needs to hike again, which would be a different kind of mistake. Luna: And the market seems to think the Fed isn't going to hike. The fed funds futures, I think, are pricing in a cut by the end of the year. Is that consistent with the steepening? Lucas: It can be, actually. The market can expect a cut in the near term, but still demand a higher term premium on the long end because of inflation and supply. That gives you a steep curve. So it's not contradictory. But it does highlight a divergence: the Fed is saying, ‘we're data dependent,’ and the market is saying, ‘we think you'll be cutting soon.' Luna: And that's the kind of divergence that can lead to a policy mistake. If the Fed cuts too soon, inflation could re-accelerate. If it waits too long, the curve steepens further and the economy slows more than needed. Lucas: Right. And there's another layer here. We've seen this with global central banks. Singapore tightened policy in a surprise move recently, partly because of rising oil prices. That shows the inflation risk isn't just a US story. Oil prices are a wildcard for the Fed, and the market might be pricing that in. Luna: So if oil keeps climbing, the breakeven could go higher, and the curve could steepen even more. The Fed would be under pressure to act, but with growth at 1.5 percent, hiking seems counterintuitive. Lucas: It's a real bind. And that's why I think the most useful way to read this steepening is as a warning about credibility. The Fed has been talking tough on inflation, but the market is effectively saying, ‘we don't fully trust that you'll keep rates high enough.' Luna: Is there any data that would change that? Like, if core inflation starts falling more clearly, would the curve flatten? Lucas: It could. Core CPI actually dipped slightly in June, to 3.3 percent annualized. And core PCE was flat. So there's some progress. But the market is focused on the medium term, and with fiscal deficits still large, the fear is that inflation will be structurally higher. Luna: So what should an investor do with this? Is the steepening a signal to shorten duration, or is it a chance to lock in higher long-term yields? Lucas: I think it depends on your view of the Fed. If you think they'll cut, then short-term bonds look good, and the curve will steepen further as the front end falls. If you think inflation is stickier, then long-term bonds might be offering a decent real yield, but you're taking on the risk that rates go higher. Luna: Personally, I'm watching the ten-year at 4.74. If it pushes through 5 percent, that changes the conversation. That's a level we haven't seen in a while, and it would signal real concern. Lucas: Absolutely. And that's the level where the Fed would have to take notice. A 5 percent ten-year would tighten financial conditions significantly, and it could force the Fed to act, either by signaling a cut or by actually cutting. That's the kind of moment where policy becomes reactive rather than proactive. Luna: So we're in a waiting game. The data isn't weak enough to force the Fed's hand, but the bond market is getting restless. Lucas: Exactly. And that's the takeaway for today: the yield curve is sending a message, but it's not a simple one. It's a mix of inflation expectations, fiscal concerns, and the Fed's credibility. As we head into the fall, watch the ten-year, watch the oil price, and watch how the Fed talks about the data. The next move might not be a hike or a cut, but a change in tone.