Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Fed Makes of the Yield Curve Uninverting
Transcript
- Lucas: The yield curve has been inverted for more than two years now — since July 2023, if you're tracking the two-year versus ten-year spread. And for most of that time, the conventional wisdom was that an inversion this deep and this long meant a recession was all but certain. Luna: Right, the classic signal. Every inversion since the 1970s preceded a downturn. But here we are halfway through 2026, and the economy is still growing, unemployment is low — the recession never showed up. Lucas: Exactly. And now we're seeing something new. The curve is starting to uninvert. The two-year yield is still above the ten-year, but the gap has narrowed from over a hundred basis points at its peak to around twenty-three basis points as of this week. Luna: So the market is pricing in rate cuts ahead. That's the usual story — when the Fed is expected to cut, longer-term yields fall less than short-term yields, and the curve steepens. Lucas: That's part of it. But there's also something else going on. The term premium — the extra compensation investors demand for holding longer-term bonds — has been rising. It went negative during the pandemic and stayed there for years. Now it's positive again, and that alone is adding to the steepening. Luna: Meaning investors are less confident about the path of rates and inflation, so they want more insurance for locking up money for a decade. Lucas: Exactly. And from the Fed's perspective, this uninversion is actually something they'd probably welcome — as long as it doesn't happen too fast. A gradual steepening can be a sign that the economy is normalising after an aggressive tightening cycle. The Fed funds rate is at 3.63 percent right now, down just slightly from its peak. The market expects cuts later this year, but the Fed itself has been cautious about signalling a pivot too soon. Luna: So the uninversion could be a soft-landing signal. But historically, the curve has often uninverted just as the recession was starting. Isn't that the worry? Lucas: It is. If you look at the inversions in 1990, 2001, and 2008, the curve steepened sharply right before or during the downturn. The mechanism is that the Fed cuts aggressively once the economy weakens, and short-term yields fall faster than long-term yields. But the key difference this cycle is that the inversion lasted so long without a recession. Some economists argue that the signal has been distorted by the sheer scale of quantitative easing and the post-pandemic fiscal stimulus. Luna: And by the fact that the Fed started hiking late. They didn't raise rates until 2022, after inflation was already running hot. So the curve inverted earlier in the cycle than usual. Lucas: Right. So now we're in this weird place where the uninversion could mean either a soft landing — the economy slows just enough — or a recession that has been delayed, not avoided. The Fed is watching this closely. In Kevin Warsh's first meeting as chair earlier this month, the statement noted that the committee is paying attention to financial conditions, and the yield curve is a big part of that. Luna: What about the Fed's balance sheet runoff? Quantitative tightening is still ongoing, though at a slower pace. Does that affect the curve? Lucas: It does. When the Fed lets Treasuries roll off, that reduces demand for longer-term bonds, which can push yields higher. That's another reason the ten-year yield has been sticky around 4.45 percent. Some analysts estimate that QT has added roughly twenty to thirty basis points to term premiums. So the uninversion isn't just about rate expectations — it's also about supply and demand dynamics in the Treasury market. Luna: And the market knows the Fed will eventually stop shrinking the balance sheet. There's probably a debate inside the FOMC right now about when to end QT, because if you keep letting bonds roll off while cutting rates, you're sending mixed signals. Lucas: Precisely. And that leads to another angle. The curve uninverting might actually be a signal that the market thinks the Fed will cut rates sooner than the Fed itself has telegraphed. The fed funds futures are pricing in about seventy-five basis points of cuts by December. If that happens, the curve could steepen further. But if the Fed holds steady, the inversion might persist. Luna: So what's your read? Is this the start of a soft landing or the calm before the storm? Lucas: I think the most honest answer is that nobody knows. But there are a few data points I'm watching. Core PCE, the Fed's preferred inflation gauge, is at 2.6 percent year over year as of April — still above target, but coming down. The labor market is still tight, but wage growth has moderated. If those trends continue, the Fed can cut gradually and the curve can normalise without a crash. Luna: And if inflation reaccelerates, the curve would probably invert again. The ten-year breakeven rate is at 2.25 percent — down slightly, but still elevated relative to the Fed's 2 percent target. So inflation expectations are not fully anchored yet. Lucas: Which brings us back to the term premium. If investors start demanding even more compensation for inflation risk, the ten-year yield could rise even if the Fed cuts the short rate. That would steepen the curve, but it wouldn't be a happy steepening — it would be a risk-premium steepening, which tends to correlate with bad economic outcomes. Luna: So the shape of the curve matters, but the 'why' behind it matters even more. Lucas: Exactly. And I think that's what the Fed is spending a lot of time on right now — trying to parse the signal from the noise in the Treasury market. Because a curve that uninverts because of rate cuts is very different from one that uninverts because of a fiscal confidence shock. Luna: Speaking of parsing signals — if walking through the economy with us has made something click for you, there's a way to keep this conversation going ad-free and independent. Lucas: Yeah, listener support is what makes this possible. We keep the show free because people who find value in it chip in at buy me a coffee dot com slash fexingo. It's a simple way to say this kind of deep-dive is worth having. Luna: And it really does help us keep going without ads or sponsors. So if that resonates, we appreciate it. Back to the curve — Lucas, you mentioned the risk of a fiscal confidence shock. That's a pretty big deal. Lucas: It is. And it ties into something we haven't talked about yet — the debt ceiling. The suspension expired in January, and Treasury is using extraordinary measures. If Congress doesn't raise or suspend the limit by late summer, that could create a liquidity crunch in the Treasury market that would distort the curve even further. Luna: Right, because a default scare would cause short-term yields to spike as investors demand compensation for the risk of delayed payments. That could actually reinvert the curve temporarily. Lucas: Exactly. So the uninversion we're seeing right now might not be a clean signal at all. It's happening under the shadow of fiscal uncertainty, QT still running, and inflation not yet defeated. That makes it one of the most complicated yield curve environments in decades. Luna: And one that the Fed has to navigate carefully. They don't want to overreact to a steepening that might be driven by term premium rather than a weakening economy. Lucas: Right. So the bottom line is: watch the term premium, watch the fiscal calendar, and watch the Fed's language around QT. The uninversion itself isn't a crystal ball. It's a symptom of a market that is trying to price a lot of uncertainty at once.