Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Bond Market Is Betting on a Fed Pivot Here
Transcript
- Lucas: The bond market is making a very loud statement right now. The 10-year Treasury yield closed yesterday at 4.43 percent — down more than a full percentage point from its 2025 peak. That is a big move in a short time, and it is telling us that fixed-income investors believe the Fed is about to cut rates. Luna: And the Fed has been saying all year that they are in no hurry. So who's right — the bond traders or the central bank? Lucas: That is exactly the question. And the answer depends on whether you think the bond market has learned from its recent mistakes. Because, honestly, the fixed-income crowd has been wrong about the economy repeatedly since 2022. They kept pricing in rate cuts that never came. But this time feels different, and I want to explain why. Luna: Okay, walk me through it. What changed? Lucas: Let's start with the mechanics. When bond yields fall, it usually means demand for Treasuries is rising — investors are moving money out of riskier assets and into safety, or they are anticipating lower short-term rates in the future. In this case, it's mostly the latter. The 2-year yield, which is more sensitive to Fed policy, has dropped to 3.63 percent. That is actually right at the current fed funds effective rate. Luna: So the 2-year is saying the Fed is done hiking and might cut soon. The 10-year is saying the same, but with a term premium baked in. Lucas: Exactly. And when you strip out inflation expectations, the real yield on the 10-year Treasury is about 2.14 percent, using the 10-year breakeven inflation rate of 2.29 percent. That real yield is down significantly from the 2.5 percent we saw earlier this spring. The bond market is effectively saying: the economy is softening enough that the Fed will need to bring real rates down. Luna: But the Fed's own projections from the last dot plot showed rates staying higher for longer. And inflation is still above target — core CPI came in at 336.1 in May, up from 335.42 in April. That's not a clear sign of disinflation. Lucas: No, it is not. And that is the tension. The Fed looks at the real economy — job openings surged in April to 7.6 million, up from 6.9 million. That is a tight labor market. Hourly earnings are still rising, up to $37.50. From the Fed's standpoint, they cannot declare victory on inflation yet. But the bond market is looking at forward indicators: falling commodity prices, tighter credit conditions, and geopolitical shocks like the Iran situation that could actually suppress demand. Luna: Right, the headline risk from the Iran conflict is pushing energy prices up, but the bond market might see that as a temporary supply shock rather than sustained demand-pull inflation. Lucas: Exactly. And that is a crucial distinction. The breakeven inflation rate has actually dipped slightly to 2.29 percent, which tells you that bond investors do not expect the energy spike to feed through into long-term inflation expectations. They think the Fed will look through it, especially if the real economy starts to cool. Luna: So what would it take for the bond market to be wrong this time? For the Fed to actually hold steady? Lucas: Three things. One: if job growth reaccelerates. We saw nonfarm payrolls hit 159 million in May — that's up 172,000 from April. If that pace picks up, the Fed will stay on hold. Two: if core inflation ticks back above 3.5 percent. Right now it's running around 3.2 percent on a year-over-year basis, but the monthly prints matter more. Three: if the consumer keeps spending. Real GDP growth annualized was just 1.6 percent in Q1, but consumption was stronger. If that holds up, the economy can tolerate higher rates. Luna: And the bond market is betting the opposite on all three. That is a pretty big bet. Lucas: It is. But here is where I think the bond market has a point. Look at the yield curve — the 2-year versus 10-year spread is essentially flat, maybe ten basis points. That is not deeply inverted like it was last year. The curve is normalizing, which historically happens before rate cuts. Also, the Fed's own real rate — the fed funds rate minus core PCE inflation — is roughly 2.7 percent. That is restrictive. At some point, that bites. Luna: So you are leaning toward the bond market being right this time? Lucas: I am saying the conditions are aligning for a pivot, but the timing is uncertain. The bond market is pricing in two quarter-point cuts by year-end. The Fed is saying maybe one, maybe none. I think the market is closer to the truth, but the path is going to be bumpy. If we get another hot CPI print next month, all bets are off. Luna: It is interesting — for months we talked about the bond market being wrong about recession. Now it is not even predicting a recession, just a slowdown that forces the Fed's hand. Lucas: Which is more reasonable. The bond market has become more nuanced. They are not shouting recession; they are shouting 'policy mistake' if the Fed keeps rates too high for too long. And that is a subtler signal. Luna: Yeah, I think that nuance gets lost. The yield curve uninverted without a recession, which we covered a while back. Now the curve is normalizing further, and people might misinterpret it as a recession signal when it is actually just a repricing of rate expectations. Lucas: Exactly. And one more data point: the interest on reserve balances is 3.65 percent, essentially at the fed funds rate. That tells you the Fed is comfortable with current liquidity. They are not being forced to cut by funding stress. This is a deliberate choice to wait for more data. Luna: So the bond market is essentially saying: you are waiting too long. Lucas: That is the bet. And it is a high-conviction bet — the move in yields has been sharp and sustained. If the bond market is wrong again, we could see a violent snapback, with yields surging back toward 5 percent. That would hurt everyone holding long-duration bonds. Luna: But if the bond market is right, then the Fed will cut, and those who bought bonds now will look smart. Lucas: That is the trade. And it is a classic macro call: do you trust the central bank's forward guidance, or do you trust the price action in the most liquid market in the world? Historically, the bond market has a decent track record on the direction of rates, if not the exact timing. Luna: It is worth noting that the ECB just hiked rates for the first time since 2023 because of the Iran energy shock. So globally, central banks are still tightening. The Fed is the outlier if they cut. Lucas: That is a great point. The ECB move shows that energy-driven inflation is still a concern elsewhere. The US is more insulated because we are a net energy producer, but we are not completely immune. If oil stays elevated, it could feed into core goods down the line. Luna: So the bond market is making a very specific bet: that the US economy slows enough to offset any energy inflation, and that the Fed will act preemptively. Lucas: That is exactly right. And I think that is a reasonable baseline. But reasonable does not mean certain. The next two months of data will decide it. If jobless claims keep creeping up — they were 229,000 last week, up from 225,000 — that is a small crack. If that becomes a trend, the bond market will look prescient. Luna: And if claims fall back and payrolls accelerate, the bond market will have to unwind. Lucas: Right. So we are in a waiting game. But the bond market has placed its bet, and the stakes are high. Luna: You know, it is conversations like this that make me appreciate that this show is ad-free. We can take the time to dig into the mechanics without selling something. Lucas: Yeah, that is by design. We deliberately don't run ads on these episodes because we want the analysis to be clean and focused on what matters. If that kind of independence resonates with you, there is a simple way to support it. Luna: Exactly. If walking through the economy with us has made something click, you can find us at buy me a coffee dot com slash fexingo. No pressure, just a way to keep this going. Lucas: And we appreciate everyone who listens. Now, back to the bond market — I want to talk about one more signal that is often overlooked: the shape of the forward curve. Luna: I was wondering when you would get to that. Lucas: The forward curve for the fed funds rate six months out is implying a rate of about 3.25 percent. That is nearly forty basis points below the current spot rate. That is a strong signal that the market expects cuts. And if you look at the eurodollar futures, they are pricing in even more easing. Luna: So the entire futures complex is aligned. That is rare. Lucas: It is. And when the futures market, the bond market, and the swap market all tell the same story, it carries weight. But again, the Fed has been resistant. The question is: will the data force their hand, or will they hold the line? Luna: We will find out soon enough. The next FOMC meeting is in July, and the July CPI print will come out right before. That will be the moment of truth. Lucas: That is the key date. Until then, we watch the bond market's bet and see if the economy cooperates.