Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Yield Curve Uninversion
Transcript
- Lucas: So the yield curve has been inverted for over two years now — since July 2023, actually. That's the longest stretch since at least the late 1970s. But in the last few weeks, something's shifted. Luna: The curve is starting to uninvert. The 2-year and 10-year spread is down to maybe 15 or 20 basis points, depending on the day. Lucas: Right. As of this week, the 2-year is at 4.18%, the 10-year at 4.47%. A positive spread of around 29 basis points. That's not normal after more than two years of negative spreads. Luna: Historically, an uninversion has often preceded a recession. The curve flattens, then re-steepens, and then the economy tips over. Lucas: Exactly. Every US recession since the 1970s has been preceded by the curve turning positive again. The signal is when the short end comes down faster than the long end — the market pricing in rate cuts. Luna: But this cycle has been weird. The inversion lasted way longer than anyone expected. And the economy hasn't actually rolled over yet. Lucas: Yeah. And if today was actually useful to you, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. Luna: We really appreciate that. It keeps us independent. Lucas: So back to the curve — why has this inversion been so stubborn? I think it's the lag between the Fed's rate hikes and when they actually bite. The Fed started hiking in 2022, paused, cut a bit, then held. The economy was surprisingly resilient. Luna: And the long end stayed anchored by expectations of lower inflation and perhaps a slowdown. So the spread stayed negative. Lucas: Now, with the 10-year at 4.47%, the 2-year at 4.18%, we're seeing the short end drop. The market is pricing in that the Fed will cut rates sooner rather than later, given that core CPI is still sticky at 4.2% annually. Luna: But the Fed hasn't signaled cuts yet. The fed funds rate is 3.62% — still above the 2-year yield, which is unusual. Lucas: That's the classic inversion dynamic — short-term rates above long-term rates. But as the curve normalizes, the question is: does it mean the soft landing is real, or is it the calm before a downturn? Luna: Historical track record favors recession. But every cycle is different. Lucas: Let's look at the data. The last time the curve uninverted was in 2019, after a brief inversion in late 2018. The Fed cut rates, the curve steepened, and then we had the COVID recession in 2020. But that was an exogenous shock. Luna: Before that, 2007. The curve inverted in 2006, then uninverted in early 2007, and the Great Recession started later that year. Lucas: 2001 — the curve inverted in 2000, uninverted in early 2001, and the dot-com bust recession was already underway. 1990 — inversion in 1989, uninversion in early 1990, recession mid-year. Luna: So the pattern is consistent: the curve flips back positive, and within a year, recession arrives. Lucas: But the lead time varies. In 2019, it was about 6 months before COVID. In 2007, it was 8 months. Sometimes it's as little as 3 months. Luna: So if the curve fully uninverts this summer, say by August, then we might be looking at a recession sometime in late 2026 or early 2027. Lucas: That's the consensus view. But there's a counterargument: this time, the inversion lasted so long that maybe the signal is degraded. Some economists argue that the term premium has been compressed by quantitative easing and global demand for safe assets. Luna: So the curve might be less predictive than it used to be. The Fed's balance sheet is still large, and foreign central banks hold a lot of Treasuries. Lucas: But the term premium is positive again — it turned positive in 2025 after being negative for years. So the curve might be more informative now. Luna: What's the Fed saying? Have any FOMC members commented on the curve? Lucas: Not explicitly. They tend to downplay yield curve signals, preferring to look at real activity data. But internally, they must be watching it. Luna: Especially with the ECB hiking rates last week for the first time since 2023. That tightens global financial conditions. Lucas: Right. The ECB is dealing with energy-driven inflation from the Iran conflict. Their hike puts upward pressure on yields globally, which could steepen our curve from the long end. Luna: But the US 10-year hasn't moved much. It's been around 4.5% for weeks. Lucas: Because the market is focused on the domestic outlook. The May CPI print showed 4.2% annual headline inflation, core at 4.1%. That's above the Fed's target, but the trend is slightly down from earlier in the year. Luna: And the PCE price index, which the Fed prefers, is at 130.9 — up 0.4% from March. Core PCE at 129.6. Still sticky. Lucas: So the Fed is in a bind. They want to cut rates to avoid a recession, but inflation isn't low enough yet. The market is pricing in cuts anyway. Luna: That's why the short end is falling — the 2-year yield dropped from 4.35% a month ago to 4.18% now. The market sees a cut in the fall. Lucas: But if inflation doesn't cooperate, the Fed might hold, and then the curve could invert again. That would be a whipsaw. Luna: Another thing: the 10-year breakeven inflation rate is at 2.31%, up from 2.29% last week. That suggests inflation expectations are rising, not falling. Lucas: That makes it harder for the Fed to ease. If they cut and inflation expectations unanchor, they lose credibility. Luna: So the uninversion might be a false signal if the Fed doesn't actually cut. Lucas: Exactly. The historical examples all had the Fed cutting rates before or during the uninversion. If the Fed holds steady, the curve might stay inverted or re-invert. Luna: What about the neutral rate? The Fed's estimate of r-star is around 1% real, maybe 3% nominal. With the fed funds at 3.62%, policy is restrictive. Lucas: But not extremely restrictive. The real fed funds rate is about 2.3% using core PCE. That's above neutral, but not as high as in previous tightening cycles. Luna: So the economy might not be as sensitive to rate hikes as in the past. That could explain why the recession hasn't arrived yet. Lucas: And why the curve has been inverted so long — the economy is absorbing the higher rates. But eventually, the lag catches up. Luna: I want to look at the small-cap rally. The Russell 2000 is up nearly 4% in the last five days. That's often a sign that investors expect rate cuts. Lucas: Small caps are more sensitive to domestic economic conditions and borrowing costs. So a rally suggests the market is pricing in a soft landing with cuts. Luna: But if the recession comes, small caps get crushed. So it's a bit of a gamble. Lucas: Let's step back and think about what the Fed actually cares about. They have a dual mandate — maximum employment and stable prices. The labor market is still strong,with unemployment at 3.8% in May. So they can afford to wait on inflation. Luna: But the financial conditions are tightening via the curve. Even if the Fed doesn't move, the market is doing some of the work for them. Lucas: That's the key insight. The yield curve uninversion is itself a tightening of financial conditions, because it reduces the penalty for holding long-term bonds and signals future rate cuts that may not come. Luna: So the Fed might interpret a smooth uninversion as a sign that policy is working — inflation is coming down, and the economy is slowing gradually. Lucas: But a sharp, rapid steepening would be a red flag. That would indicate panic pricing of rate cuts due to imminent recession. Luna: Right now, the steepening is gradual. The 10-year is up only slightly, the 2-year is down. That's the classic 'soft landing' pattern. Lucas: But we've seen this movie before. In 2007, the curve uninverted gradually, and then the recession hit. The gradual move can be deceptive. Luna: So what's the takeaway for listeners? Are we headed for a recession or not? Lucas: I think the honest answer is: the yield curve is sending a warning, but it's not a certainty. The historical record is strong, but each cycle has unique features. This time, the long inversion, the post-pandemic distortions, and the global energy shock from Iran all complicate the picture. Luna: So the Fed is watching, the market is betting, and we'll know more in a few months. Lucas: Exactly. For now, the curve uninversion is the story to track. If it continues, expect more recession talk. If it stalls, the soft landing narrative holds. Luna: Great conversation. See you next time. Lucas: Take care.