Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Yield Curve Is Flashing a Different Signal Now
Transcript
- Lucas: So, the yield curve inverted in April 2022 — that's over four years ago now — and it's been one of the most watched recession signals in modern market history. But this week, something interesting happened. Luna: Let me guess — it's starting to steepen again? Lucas: Exactly. Look at the numbers. Over the last five trading days, the 10-year Treasury yield dropped about 1.4 percent — it's now at 4.56 percent. Meanwhile, the 2-year yield actually ticked up slightly to 3.59 percent. That's a compression of what's called the 'short-end' part of the curve. The spread between the 2-year and the 10-year is still inverted — negative 97 basis points — but it's less inverted than it was two weeks ago. Luna: So the curve is steepening in a way that usually happens before a recession, but we're not in one. GDP just printed at 2 percent annualised for Q1. Lucas: Right. Real GDP came in at 2 percent, up from just 0.5 percent in the prior quarter. So the economy is actually accelerating. And the unemployment rate is holding at 4.3 percent. By most cyclical indicators, we're not tipping into a downturn. But the bond market is clearly pricing something different. Luna: It's pricing a combination of fiscal risk and maybe some inflation stickiness. The 10-year breakeven inflation rate is at 2.40 percent — that's up slightly from 2.39 last week. So inflation expectations aren't collapsing. Lucas: That's the key tension. The Fed has held the fed funds rate at 3.64 percent effective since last April. The market is pricing that they'll cut maybe once this year, not more. But the long end of the curve is also being pushed around by the supply of Treasuries — the government is issuing a lot of debt. And now you have this geopolitical overlay with the Iran situation pushing oil prices higher, which feeds into consumer sentiment. Luna: Consumer sentiment hit a record low in May. That's the headline from last week. So households are gloomy, but they're still spending. The economy is running on a weird mix of fiscal stimulus, ai driven investment, and a tight labour market. Lucas: And that mix is exactly what makes this yield curve signal different from past cycles. Normally, an inverted curve that starts to steepen means the Fed is about to cut aggressively because something broke. But here, the steepening is happening because the long end is falling — not because the short end is rising. The market is actually lowering long-term growth expectations even as short-term data holds up. Luna: So the bond market is saying 'I believe the economy is slowing eventually, just not right now.' Lucas: Precisely. And that's a very different message from the equity market, where small caps just rallied 3.4 percent in a week. The Russell 2000 is at 2,869. Investors are piling into rate-sensitive names, betting that the Fed will cut and that the AI boom will lift all boats. But the bond market is saying 'slow down, not so fast.' Luna: Which side wins? We've seen this movie before — the bond market has been right more often than stocks in predicting economic turns. Lucas: It's not a clean call. I think the real story is that the yield curve is no longer just a recession signal — it's also a fiscal signal. The US is running a deficit around 6 percent of GDP even with a strong economy. That's unprecedented. The bond market is saying 'you can't keep doing this without higher term premiums.' And that's what you're seeing in the 10-year holding above 4.5 percent even as the Fed holds short rates steady. Luna: So the term premium — the extra compensation investors demand for holding long-term bonds — is rising because of supply concerns. That's a structural shift, not a cyclical one. Lucas: Exactly. And that means the curve could stay inverted for longer even if the economy slows. The old playbook of 'inversion equals recession in 12 to 18 months' might not apply when the government is issuing so much debt. We might get a 'softish' landing where growth slows but doesn't turn negative, and the curve normalises through a combination of Fed cuts and higher long-term yields. Luna: That sounds like the worst of both worlds for bond investors — you get the price depreciation from higher yields, but not the safety bid from a recession. Lucas: And that's exactly what we're seeing. The 30-year bond yield actually rose 1.6 percent this week — it's at 5.06 percent now. So the long end isn't rallying; it's selling off. The 10-year is down because of a flight to safety from geopolitical headlines, but the 30-year is up because of supply. That's a split that tells you the market is very uncertain about the path ahead. Luna: It's interesting — we talk about the yield curve as this monolithic indicator, but there are really three different curves at play: the nominal curve, the real curve from TIPS, and the breakeven curve. What are they saying separately? Lucas: Great question. The real yield curve — that's TIPS yields — has steepened even more dramatically. The 10-year real yield is around 2.16 percent, up from 2.0 percent a month ago. That suggests the market is demanding higher real returns, which is typically a sign that growth expectations are being marked up. But the nominal curve is saying the opposite. So the breakeven — the difference between nominal and real — is compressing. That means inflation expectations are actually edging down slightly, even as CPI came in hot at 332.4 in April, up from 330.3. Luna: So the market is pricing higher real growth but lower inflation. That's a Goldilocks scenario — if you believe it. Lucas: And that's the $64,000 question. Do you believe the market, or do you believe the data? The data says core PCE is still running around 2.8 percent — above the Fed's 2 percent target. The labour market is still tight with jobless claims at 209,000. Wages are growing at 3.7 percent year-over-year. All of that says inflation is sticky. But the bond market is pricing that the Fed will eventually win, and that ai driven productivity gains will cool price pressures over time. Luna: It's a bet on technology overcoming fiscal and geopolitical headwinds. That's a very 2020s kind of bet. Lucas: Yeah, and it's not unreasonable. But it's a bet. And the yield curve is the arena where that bet is being made every day. Look, we spend a lot of time on this show walking through these numbers and trying to make sense of them. And one thing I really appreciate is that we can do it without any ads. No sponsors, no breaks for a car commercial or a mattress company. It's just us, the data, and the listener. Luna: Yeah, and that's intentional. We want this to be a resource that's clean and focused. If you find value in that — if walking through the economy with us has made something click — you can support that choice. It's buy me a coffee dot com slash fexingo. That's it. Lucas: And it genuinely helps. So, back to the curve — one more data point I think is worth watching: the 5-year yield. It's at 4.26 percent, down 0.6 percent this week. That's the belly of the curve. It's falling faster than the 2-year but slower than the 10-year. That tells me the market is pricing a moderate slowdown in the 2- to 5-year window, but not a crash. Luna: So the belly is where the recession pricing lives, if there is any. And it's not flashing red. Lucas: Exactly. If you look at the 2-year/10-year spread versus the 3-month/10-year spread — the latter is still deeply inverted at around minus 140 basis points. That's the one that has historically been the best recession predictor. It's still very negative, but it's been negative for so long that people are starting to question its reliability. Maybe this time really is different because of the fiscal backdrop. Luna: Or maybe it's just taking longer. The inversion started in 2022, and we're now in mid-2026. That's four years. Historically, the lag has been 12 to 24 months. So either the signal is broken, or the recession is delayed by extraordinary fiscal and monetary intervention. Lucas: I lean toward the latter. The Fed has kept rates high, but the Treasury has been pumping trillions into the economy through deficits. That's kept aggregate demand afloat even as monetary policy tightens. It's like a tug of war between fiscal and monetary policy, and the yield curve is the rope. Luna: So what should an investor do with this information? Just watch? Or is there a trade? Lucas: I'm not going to give trading advice, but I think the macro takeaway is that the curve is sending a nuanced message. If you believe the recession is coming, you'd be short equities and long duration. If you believe the ai driven expansion continues, you'd be long small caps and short duration. The market is pricing a bit of both. The safest bet might be to just acknowledge the uncertainty and position for a range of outcomes. That's not a great hook for a podcast, but it's the honest answer. Luna: It's the honest answer, and it's why we do this show. No hot takes, just the data and the context. Lucas: And the yield curve is giving us a lot of context right now. So keep watching the 2-year versus 10-year spread, but also watch the 5-year and the 30-year. The whole curve matters, not just one slice. Luna: Alright, thanks Lucas. And thanks to our listeners. We'll be back tomorrow with another episode.