Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The 10-Year Breakeven Tells a Different Inflation Story
Transcript
- Lucas: So the core PCE number came out yesterday — 3.4 percent year-over-year, highest since October 2023. That's the Fed's preferred inflation gauge, and it's clearly still elevated. But if you look at the bond market, you get a very different picture. Luna: You're talking about the 10-year breakeven inflation rate, right? Lucas: Exactly. It's sitting at 2.21 percent as of yesterday. That's up just a couple of basis points from a week ago, and it's actually below where it was for most of last year. So we have this interesting disconnect: hard inflation data running hot, market-based expectations staying cool. Luna: Walk me through the mechanics. The breakeven is the difference between the nominal 10-year yield and the real yield on 10-year TIPS, right? Lucas: Right. The nominal 10-year is at 4.39 percent. The 10-year TIPS real yield — let me pull that — is around 2.18 percent. The difference is 2.21. That's the average annual inflation the market expects over the next decade. Luna: So the market is basically saying inflation will average just over 2 percent for the next ten years. That's basically on top of the Fed's target. Lucas: Exactly. And that's despite core PCE running at 3.4 and headline CPI at — let's see — 334.0 index level, which is about 3.3 percent year-over-year. So the bond market is essentially betting that the current spike is temporary. Luna: Is that a smart bet? I mean, we've been hearing 'transitory' before, and it didn't exactly age well. Lucas: Fair point. But there are reasons to think the breakeven might be more reliable than the backward-looking CPI and PCE numbers. For one, the breakeven is forward-looking — it's an average of expected inflation over ten years, not a snapshot of the past twelve months. Luna: Still, if actual inflation stays elevated for another year or two, those expectations should adjust upward. Why haven't they? Lucas: Great question. One theory is that the bond market sees the Fed holding rates at 3.63 percent — or maybe even cutting later this year — but that doesn't necessarily mean they expect inflation to reignite. Remember, the real fed funds rate is about 1.4 percent if you use the breakeven as your inflation gauge. That's not particularly restrictive. Luna: But if you use core PCE at 3.4 percent, the real rate is basically zero. Lucas: Right, and that's the tension. The bond market is saying inflation expectations are anchored. The data is saying inflation is sticky. The Fed is caught in the middle, and they've been data-dependent — which means they're probably not cutting until they see sustained improvement. Luna: So which side is more likely to be wrong? The bond market or the inflation data? Lucas: Historically, the breakeven has been a decent predictor of average inflation over long horizons — better than surveys, anyway. But it's not perfect. There can be liquidity premiums in TIPS, or flight to safety flows that distort the real yield. Right now, TIPS are also in high demand because pension funds and insurers are hedging long-dated liabilities. Luna: That could be pushing real yields lower and the breakeven higher, actually. If TIPS are bid up, their yield drops, and the difference with nominal yields widens. Lucas: Correct. So if anything, the breakeven might be slightly overstated due to technical demand. That makes the 2.21 percent even more striking — because it implies the market's genuine inflation view might be closer to 2 percent. Luna: But let's talk about the other side. What if the bond market is too complacent? We had factory job cuts in June that approached financial-crisis levels, according to S&P. That's a sign of weakness, not overheating. Lucas: That's a really important point. The labor market is showing a split — job openings surged to 7.6 million in April, but hiring remains sluggish. And factory layoffs are spiking. So the economy isn't uniformly strong. That might be why the bond market isn't panicking about inflation — they see softening demand. Luna: Yet the unemployment rate is still only 4.3 percent, and initial jobless claims just dropped to 215,000. That's low. Lucas: It is. So we have this mixed picture: services inflation staying hot, goods disinflation fading, labor market tight but with pockets of weakness. The market is essentially pricing in a soft landing — inflation drifts back to 2 percent without a recession. Luna: And the Fed is still at 3.63 percent. If they hold here and inflation comes down, real rates will rise automatically — that's a tightening without any action. Lucas: Exactly. That's the 'automatic stabilizer' argument. If the breakeven is right, the Fed can afford to wait. If the breakeven is wrong and inflation stays around 3 percent, they'll have to hike again, which would be a shock to markets. Luna: So which scenario do you lean toward? Lucas: I think the next few months are critical. We've got Q2 GDP data coming out in late July, and that will show whether real growth is still holding at that 2.1 percent annualized rate. If growth slows and inflation stays sticky, that's stagflation-lite — bad for both bonds and equities. Luna: And if growth holds up and inflation moderates, then the breakeven wins. Lucas: Right. But the bond market is already voting with its wallet. The 10-year breakeven is telling us that the inflation scare of the past few years is fading in the minds of investors. Whether that's wisdom or wishful thinking, we'll find out soon. Luna: I think conversations like this — where we actually dig into the data and the assumptions — are exactly why people listen to this show. Lucas: That means a lot. And it's also why we keep this show ad-free. We don't want to interrupt the signal with commercials. If you find value in walking through the economy with us, the simplest way to support that is at buy me a coffee dot com slash fexingo. No pressure — just if it's been useful to you. Luna: Yeah, it really helps keep the lights on. And we genuinely appreciate everyone who's chipped in. Lucas: Alright, back to the breakeven. One more angle I want to explore: the five-year breakeven is actually a bit higher than the ten-year — around 2.4 percent. That's a classic pattern when the market expects near-term inflation to be higher than the long-run average. Luna: So the market thinks inflation will be above 2 percent for the next five years, then settle down. Lucas: Right. The five-year five-year forward breakeven — that's the market's expectation for inflation from 2031 to 2036 — is around 2.1 percent. That's very well anchored. So the bond market is not predicting a structural shift upward in inflation. Luna: That's actually pretty reassuring. Unless the near-term inflation stays high enough that the Fed is forced to act, and that derails the soft landing. Lucas: Exactly. And that's the key risk. The fed funds rate at 3.63 percent is not high by historical standards, but if inflation doesn't come down, the real rate will stay low, and the Fed might need to go again. That would push the breakeven down — because tighter policy reduces inflation expectations — but it would also hurt growth. Luna: So the breakeven is a useful signal, but it's not a crystal ball. It's a reflection of current market consensus, which can change quickly. Lucas: Exactly. And that's the value of watching it — not as a prediction, but as a real-time read on how the smartest money in the world is interpreting the data. Right now, that read is: inflation is a problem, but not a permanent one. Luna: And we'll check back in a few months to see if that bet pays off. Lucas: Absolutely. For now, the 10-year breakeven at 2.21 percent is the story the bond market is telling. We'll keep watching.