Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / Why the Yield Curve Is Still Steep in a Stagflation Era
Transcript
- Lucas: So we keep hearing about the 1970s echoes, but there's one number that doesn't fit the script at all. The two-year Treasury is sitting at around four and a quarter percent, while the ten-year is closer to four and a half. That's a positive spread of roughly twenty-five basis points. In a classic stagflation playbook, that curve should be flat or inverted by now. Luna: Wait, I thought the yield curve was still inverted. Everyone's been talking about that for two years. Lucas: Right, that was the story through 2024 and most of 2025. But this year the curve has re-steepened. And here's the twist: it's happening even though the Fed is talking about hiking rates, not cutting them. Fed Governor Hammack said on Thursday that 'now is the time to act' on raising rates. And Chair Warsh is out there saying he's concerned about inflation and wants a 'quieter' central bank. That should push short-term yields up, but long-term yields are holding their ground. So the question is, what is the bond market telling us that the equity market isn't? Luna: Maybe it's telling us that the Fed is behind the curve. If inflation is sticky and the Fed is slow to react, long-term yields stay high because investors demand more compensation for that risk. Lucas: Exactly. And that's where the term premium comes in. The term premium is the extra yield investors require to hold a long-term bond instead of rolling over short-term bills. For most of the past decade, it was negative. Now it's positive again, and it's been creeping up. That's a sign that bond investors are no longer willing to subsidize the government's borrowing costs. Luna: So if today was worth a coffee to you, that's the link. Buy me a coffee dot com slash fexingo. We keep these episodes ad-free, and that's because of listeners who chip in. It's a small ask, but it keeps the lights on. Lucas: Yeah, honestly, if you've gotten one useful idea from this conversation, that's the way to support us. It's just buy me a coffee dot com slash fexingo. No pressure, but it does help. Luna: And we're back to the curve. So the term premium is rising. What's driving that? Lucas: A few things. First, the supply of long-term Treasuries is massive. The government is running deficits around one and a half trillion dollars a year, and they're financing it with longer-dated debt. That's a lot of paper that needs to be absorbed. Second, there's fiscal dominance. When the Fed is reluctant to tighten too aggressively because it would spike borrowing costs for the Treasury, investors start to doubt the Fed's inflation-fighting credibility. They demand a higher term premium as compensation for that doubt. Luna: So the bond market is basically saying, we don't trust the Fed to stay tough on inflation. Lucas: That's part of it. But it's also saying that even if the Fed does hike, the real economy might not handle it well. We just saw real GDP growth slow to one point five percent annualized in the second quarter. That's down from two point one percent in the first quarter. And the Fed's preferred inflation gauge, core PCE, is still running at three point three percent annually. That's a stagflation portrait if I've ever seen one. Luna: And yet the unemployment rate is at four point one percent, which is low. How does that fit? Lucas: That's the puzzle. The labor market is still tight by historical standards, but it's cooling. Job openings have fallen to about seven point four million, and payroll growth has slowed to a trickle. So the economy is losing momentum, but inflation is still above the Fed's two percent target. That's the classic stagflation trap: you can't ease because inflation is high, and you can't tighten because growth is weak. Luna: So what does the steepening yield curve mean for the average person? Mortgages, car loans, that kind of thing? Lucas: It means long-term borrowing costs stay elevated. The thirty-year fixed mortgage is already above six point five percent, and if the ten-year keeps climbing, that could push it higher. For anyone looking to buy a home, that's a real affordability squeeze. And it's also a signal to investors: don't expect the bond market to ride to the rescue with lower long-term rates anytime soon. Luna: So the curve is steepening, but it's not because the economy is booming. It's because long-term yields are rising due to term premium and fiscal concerns, while short-term yields are being held up by the Fed's hawkish stance. Lucas: Exactly. That's a bear steepening, not a bull steepening. And historically, a bear steepening in a stagflationary environment is a warning sign. It's happened before, in the late 1970s, and it didn't end well for the stock market. Luna: But stocks are near record highs right now. The S&P 500 is at seventy-seven hundred, up almost one percent in the last week. How do you square that? Lucas: That's the disconnect. Equity investors are still priced for a soft landing, or at least a mild recession. But bond investors are pricing in a more uncertain future. The ten-year breakeven inflation rate, which is the market's expectation for average inflation over the next decade, has dipped to two point three one percent. That's actually down from two point three three a week ago. So inflation expectations are well-anchored for now, but the term premium is what's pushing long-term yields up. It's not about inflation expectations running away; it's about investors wanting more compensation for the risk of holding government debt. Luna: So what would break this dynamic? What would make the curve invert again or flatten? Lucas: If the Fed actually follows through on a hike and the economy stumbles, short-term yields could stay high while long-term yields fall as investors flee to safety. That would flatten the curve, or even invert it. But so far, the Fed is talking tough, but the market is skeptical they'll act. The futures market is only pricing in a fifty-fifty chance of a hike by September. So the bond market is basically saying, we'll believe it when we see it. Luna: And if they don't act, then long-term yields stay high, and the Treasury's borrowing costs keep rising, which adds to the deficit. That's a feedback loop. Lucas: It is, and that's why fiscal dominance is such a concern. The Treasury has to roll over a huge amount of debt, and if they have to pay higher yields to do it, that's more interest expense, which is already over a trillion dollars a year. It's a vicious cycle. Luna: So what should investors do with this information? Is there a playbook for a bear steepener in stagflation? Lucas: Historically, in a stagflationary bear steepener, you want to be in real assets that benefit from inflation, like commodities, and maybe short-duration bonds or inflation-protected securities. But you also want to be selective with equities because the market is likely to be volatile. The fact that gold and gold miners have pulled back this week, despite inflation staying high, is actually a warning sign that the market is questioning whether the Fed will really get tough. Gold is down four percent on the week, and the miners are down nearly four percent as well. That's a big move. Luna: That is a big move. Is that because investors are expecting a rate hike, which would be negative for gold? Lucas: Partially. A rate hike would strengthen the dollar and boost real yields, which is typically bearish for gold. But gold had run up a lot, so some profit-taking makes sense. What I find more interesting is that bond yields haven't really moved that much on the Fed's hawkish rhetoric. The ten-year is up maybe ten basis points over the last week. That tells me the bond market isn't convinced the Fed will actually follow through. So you have this standoff. Luna: So the bond market is the adult in the room, saying, 'We're not buying the hawkish talk until we see action.' Lucas: That's a good way to put it. And if they do see action, then the curve could flatten quickly, and we might see a sell-off in risk assets. But if they don't, the term premium keeps rising, and that's a slow bleed for the economy. Luna: What about the rest of the world? Are we seeing similar dynamics in other bond markets? Lucas: Europe is in a similar boat. The ECB is also dealing with sticky inflation and weak growth. But the US is unique because the Treasury market is the global benchmark, so what happens here ripples everywhere. And with the dollar as strong as it is, it puts pressure on emerging markets that have dollar-denominated debt. That's another layer of risk. Luna: So the yield curve is essentially telling us that the era of free money is over, and we're now paying the price for years of fiscal and monetary stimulus. Lucas: That's the big picture. The term premium is a market mechanism that forces the government to pay a fair price for borrowing. For decades, it was artificially suppressed by quantitative easing and global savings gluts. Now that's unwinding, and the real cost of carrying government debt is being repriced. It's not just a US story; it's a global one. Luna: And that repricing is going to have consequences for everything from venture capital to real estate to public infrastructure spending. Lucas: Absolutely. Higher long-term rates raise the discount rate on future cash flows, which squeezes valuations on growth stocks and reduces the attractiveness of long-duration assets. We've seen that in the tech sector, but it's also affecting things like renewable energy projects that rely on cheap capital. So this is a fundamental shift, not just a blip. Luna: So what's your takeaway for someone listening who's trying to navigate this environment? Lucas: I'd say don't try to outguess the Fed. Instead, pay attention to the yield curve and the term premium as leading indicators. If the curve keeps steepening and long-term yields rise, that's a signal to be cautious and to maybe shorten your bond duration. And if you're in equities, focus on companies with strong pricing power and low debt levels, because they can weather high interest costs better. Luna: And what's your base case for the next few months? Lucas: I think we're in for a volatile autumn. The Fed has a meeting in September, and the market will be hanging on every word. If they hike, that could be the catalyst for a market correction. If they don't, the term premium keeps rising. Either way, the bond market is telling us that the easy days are over. It's going to be a bumpy ride. Luna: Well, that's a cheerful thought. But it's a useful one. Thanks for breaking down the yield curve for us, Lucas. Lucas: Thanks, Luna. And if you're listening and you've made it this far, maybe consider that coffee. It does help us keep doing this. Luna: And that's buy me a coffee dot com slash fexingo. We'll be back next week with another angle on the stagflation puzzle.