Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Yield Curve Is Flashing a Recession Signal
Transcript
- Lucas: So the yield curve has been inverted for more than two years now, and it's still sending a pretty loud signal. The two-year Treasury is yielding over 4.29 percent, while the ten-year is at 4.51 percent. That spread is narrow, but it's still inverted. Luna: Right, and historically an inverted yield curve has been one of the most reliable recession indicators. But we've been sitting here with this inversion for a while and no recession has actually materialised. Lucas: Exactly. And that's the puzzle. Normally, an inversion this long would have been followed by a downturn already. But the economy is still adding jobs — nonfarm payrolls just hit 159 million — and consumer spending has held up. Luna: So what's different this time? Is it just that the Fed is moving more slowly than in past cycles? Lucas: Partly. The Fed funds rate is at 3.63 percent, which is restrictive but not as high as in some past tightening cycles. And you've got Kevin Warsh now in his first few months as chair. His first meeting was just last week, and the message was basically 'we're data dependent, inflation is still sticky.' Luna: Core CPI is running at 336.1 on the index, up from last month. So inflation is still above the Fed's target, even if it's not accelerating. Lucas: Right. And the bond market's breakeven inflation rate — that's the difference between nominal and inflation-protected yields — is at 2.25 percent. That suggests investors expect inflation to stay around that level over the next decade, which is above the Fed's 2 percent target but not wildly so. Luna: So the bond market is basically saying 'we think inflation will be a bit sticky, but not out of control.' And the yield curve inversion is saying 'we think growth will slow.' Those two signals together are kind of contradictory. Lucas: They are. And it's why the Fed is in a tough spot. If they cut rates to address the growth concern, they risk letting inflation re-accelerate. If they hold steady or hike, they risk tipping the economy into recession. Real GDP growth is already only 1.6 percent annualised — that's not robust. Luna: That's pretty sluggish. And with job openings at 7.6 million, the labor market is still tight, but hiring has slowed. So you've got this weird mix of slowing growth and still-tight labor markets. Lucas: Yeah, it's a classic stagflationary vibe, though not as extreme as the 1970s. The question is whether the yield curve is wrong this time, or just early. Some economists argue that the curve has been distorted by quantitative easing and global demand for safe assets. Luna: Meaning the traditional signal might be less reliable now because the bond market is being influenced by factors other than just growth expectations. Lucas: Exactly. For example, foreign investors buying U.S. Treasuries for safety can push long-term yields down, which steepens or inverts the curve regardless of domestic growth outlook. So the signal is muddier. Luna: But the Fed still watches it closely. Kevin Warsh mentioned the yield curve in his first press conference, didn't he? Lucas: He did. He said the Fed is monitoring the curve but doesn't see it as a deterministic forecast. He emphasised that the economy is still growing, albeit slowly, and the labor market is still adding jobs. Luna: So they're basically saying 'we see the warning light, but we're not hitting the brakes yet.' Lucas: Right. And that's the tension. The bond market is pricing in a higher probability of a recession over the next 12 months, but the real economy data is still mixed. Initial jobless claims just dropped to 226,000, which is low. So layoffs aren't surging yet. Luna: But we've seen this before — the yield curve inverted before the 2008 recession, and it stayed inverted for months before the economy actually contracted. Lucas: Yeah, the lead time can vary a lot. Historically, it's been anywhere from 6 to 24 months. We're past the 24-month mark now, so either the signal is false or the recession is delayed. Luna: What would make it false? Could it be that the neutral rate — the rate that neither stimulates nor restricts — is higher than the Fed thinks? Lucas: That's a very popular argument right now. If the neutral rate is closer to 4 percent, then 3.63 percent isn't all that restrictive. The economy might just be settling into a lower-growth equilibrium rather than heading for a crash. Luna: So the yield curve might be signalling a slowdown, not a recession. A soft landing, essentially. Lucas: Exactly. And that's the bull case. The Fed manages to bring inflation down gradually without triggering mass layoffs. The breakeven inflation rate at 2.25 percent suggests that's what the bond market expects. Luna: But the downside risk is that inflation stays sticky, the Fed has to keep rates higher for longer, and then something breaks — like commercial real estate or consumer debt. Lucas: Right. And that's the hard landing scenario. The yield curve is essentially a bet on which of those two paths we take. Right now, the curve is still inverted, which means the bond market is leaning toward the hard landing. Luna: You know, if walking through the economy with us has made something click — like why the yield curve matters or how the Fed thinks — we'd love it if you considered supporting the show. Lucas: Yeah, it's a small thing, but it makes a big difference for keeping the podcast ad-free. If today's episode was worth a coffee to you, that's the link: buy me a coffee dot com slash fexingo. Luna: Honestly, it's just a nice way to say 'this is valuable.' And it helps us keep doing these daily deep dives. Lucas: Okay, back to the curve. So we've got this inverted curve, but we also have the short end of the curve — the 1-month and 3-month bills — yielding around 3.68 percent. That's actually below the Fed funds rate, which suggests the market expects a rate cut soon. Luna: That's interesting. So the very short end is pricing in a cut, while the 2-year and 10-year are still inverted. That seems like a mixed signal. Lucas: It is. The market seems to expect a cut in the next few months, but then a longer period of rates staying lower. That's consistent with a soft landing where the Fed cuts a couple of times and then holds. Luna: But if the economy slows more sharply, they'd cut more aggressively. So the curve is sort of averaging those two scenarios. Lucas: Exactly. And that's why the yield curve is still such a useful indicator — it compresses a lot of information about expectations. The challenge is interpreting it in a world where the Fed's toolkit is different and global capital flows are huge. Luna: So what's your take? Are we heading for a recession or a soft landing? Lucas: I lean toward the soft landing, but with a lot of caution. The labor market is still strong, consumer balance sheets are okay, and the Fed has room to cut if needed. But inflation is the wildcard. If it stays sticky above 3 percent, the Fed can't cut, and then the risk of a hard landing rises. Luna: So the next few CPI and PCE reports are going to be critical. If we see core inflation start to drift lower, that's a green light for cuts. Lucas: Yeah, and the market is watching the core PCE index, which is the Fed's preferred measure. It was at 129.6 last month, up a bit. If that starts to decelerate, you'll see the yield curve steepen as the market prices in cuts. Luna: And if it doesn't, we might see the curve stay inverted for even longer. Lucas: Right. And that would be a persistent warning light that the bond market is still worried about recession. So we'll be watching those numbers closely.