Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / How the Bond Market Is Pricing In Stagflation
Transcript
- Lucas: So the bond market is starting to send a very clear signal, and it's not the one the Fed wants to hear. The 10-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — climbed to 2.26 percent this week, up from 2.20 just a few days ago. Luna: And that's happening even as real GDP growth came in at just 1.5 percent annualized for Q2. Slow growth, rising inflation expectations — that's the stagflation playbook. Lucas: Exactly. And the thing is, this isn't just a theoretical worry. The actual CPI numbers, while cooling a bit, are still running hot. Core inflation — excluding food and energy — was 3.3 percent year-over-year in June. So you've got growth slowing and prices still rising faster than the Fed's target. Lucas: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making as many of these episodes as we do. If walking through the economy with us has made something click for you, that's the way to keep it rolling ad-free. Luna: Yeah, it's a small group that makes it possible. And we really appreciate it. Lucas: So back to the bond market — breakeven inflation is basically the difference between nominal Treasury yields and Treasury inflation-protected securities, or TIPS. When that spread widens, it means investors are demanding more compensation for expected inflation. And 2.26 percent is above the Fed's 2 percent target. Luna: But isn't the Fed's preferred measure the core PCE index? That came in at 2.6 percent year-over-year in June, still above target. So why focus on breakevens? Lucas: Good question. The breakeven is a forward-looking market price, not a backward-looking statistic. It tells you what bond traders think inflation will average over the next ten years. And it's rising even as the economy slows — that's the worrying part. Lucas: If growth were strong, rising inflation expectations might be a sign of overheating. But with GDP growing at just 1.5 percent, it looks more like a supply-side problem — persistent cost pressures in services, housing, and labor. Luna: And that puts the Fed in a tough spot. The CNBC headline yesterday was literally 'What a divided Fed means for investors.' Kevin Warsh — the Fed governor — has been signaling with specific phrases that the committee is split. Lucas: Right, Warsh apparently homed in on three key phrases in recent speeches. One is 'measured patience' — suggesting they want to hold rates steady. Another is 'data dependence' — a classic way to buy time. And the third is 'asymmetric risks' — meaning they see more danger in cutting too soon than in staying tight. Luna: So the bond market is basically saying: 'We think you're going to keep inflation above target even as the economy slows, and you're not going to cut rates enough to prevent it.' Lucas: Exactly. And that's a classic stagflationary bond market reaction. Nominal GDP is still growing — it's up to $32.5 trillion in Q2 — but real growth is paltry. The difference is just inflation. So investors are buying TIPS to protect against the inflation side, which pushes the breakeven up. Lucas: Meanwhile, the labor market is still relatively tight. Unemployment dropped to 4.2 percent in June, and job openings actually rose slightly to 7.59 million. So wages are still climbing — average hourly earnings are up to $37.60. That feeds into services inflation. Luna: It feels a lot like the 1970s playbook, but with a twist. Back then, the Fed under Arthur Burns kept rates too low for too long. Today, the Fed is keeping rates high, but the economy is still not cooling enough on inflation. Lucas: That's the key difference. In the 1970s, policymakers didn't believe stagflation was possible. Today, they know it is, but the tools to fight it are blunter. Raising rates further risks tipping the economy into recession. Cutting rates risks re-igniting inflation. So they're stuck. Luna: And the bond market is essentially saying: 'You're stuck, and we're pricing in a decade of above-target inflation.' That's a big vote of no confidence. Lucas: It is. And it matters for investors beyond just bond yields. If breakevens stay elevated, it influences everything from mortgage rates to corporate borrowing costs. Real estate, autos, small business loans — all of those are tied to the long end of the curve. Lucas: One more wrinkle: the yield curve is still inverted, but that inversion is narrowing. Short-term rates are high because of the Fed, but long-term rates are creeping up because of inflation expectations. That's a classic stagflation pattern. Luna: So what's the takeaway for someone listening? How should they think about their portfolio in this environment? Lucas: I think the honest answer is: diversify into real assets. Commodities, TIPS, maybe a bit of gold. The data shows gold's been rallying — it's up over 2 percent just this week. But don't abandon equities entirely. Companies with pricing power — think services, healthcare, staples — can pass on higher costs. Luna: And avoid long-duration bonds unless you're getting compensated for inflation risk. The breakeven is telling you that nominal yields aren't high enough yet. Lucas: Right. And the Fed's divided stance means we probably won't get clear guidance until we see more data. The next CPI report, the next jobs report — those will be critical. Luna: So for now, the bond market is the canary in the coal mine. And it's singing pretty loudly. Lucas: It is. And whether the Fed listens — that's the open question.