Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / Why the Bond Market Expects Lower Inflation Despite Tariff Risks
Transcript
- Lucas: So the 10-year breakeven inflation rate — that's the market's best guess for average inflation over the next decade — just ticked down to 2.26 percent. That's the lowest we've seen in months, and it's down from 2.28 percent just last week. Luna: And that's happening while headline CPI dropped from 333.98 to 332.6 in June. So the bond market is basically saying, yeah, inflation is still heading lower. Lucas: Exactly. But here's what makes this interesting: import prices from China just posted their biggest gain since 2008. And last Friday, the administration announced a new global tariff justified on forced labor grounds. So you've got this tension — the bond market is betting on disinflation, but trade policy is actively pushing costs up. Luna: So which force wins out? Let's start with the breakeven rate. For anyone who hasn't followed it, how does that number actually work? Lucas: Sure. The breakeven rate is simply the difference between the yield on a regular 10-year Treasury and the yield on a 10-year Treasury Inflation-Protected Security, or TIPS. The regular bond gives you a nominal return, the TIPS gives you a real return plus inflation adjustment. The gap tells you what inflation rate the market expects to make those two bonds equally attractive. Luna: Right — it's not a prediction from economists, it's actual money being put to work. If traders thought inflation was going to spike, they'd buy TIPS, pushing that yield down and widening the gap. Lucas: Correct. And right now the gap is shrinking. At 2.26 percent, the market is essentially pricing in inflation that's below the Fed's 2 percent target over the long run, because the breakeven includes a modest risk premium. So the message is clear: bond traders see the disinflation trend continuing. Luna: But what about the tariffs? That seems like a direct counterforce. The headline I saw said the new tariff drew rebukes from trade partners — it's not just a threat, it's policy. Lucas: Right. And import prices from China hit their highest since 2008. That matters because Chinese goods are heavily embedded in everything from electronics to apparel to industrial inputs. When those costs rise, it eventually shows up in consumer prices — but with a lag. The bond market might be looking through the noise, betting the Fed's tight policy will overwhelm any tariff-driven price bumps. Luna: So the market is basically saying the Fed is winning. But if import prices keep climbing, doesn't that eventually force the Fed's hand? Lucas: That's the key question. The Fed's preferred measure is the PCE price index, which actually ticked up in May to 131.5 from 130.94. Core PCE also rose. So the Fed sees inflation that's sticky in services and in import-sensitive categories. But the bond market is looking at the trend in goods prices and the lagged effects of high rates. The 10-year breakeven has been falling since April, so this isn't a one-week blip. Luna: I want to bring this back to everyday listeners. If the breakeven rate keeps falling, what does that mean for mortgage rates, car loans, credit cards? Lucas: Lower inflation expectations generally push long-term interest rates down. That means the 10-year Treasury yield — which is the benchmark for mortgages — could stay lower or even drop further. So if you're shopping for a home loan, this is good news. But if tariffs push inflation expectations back up, that cheap mortgage window might close faster than people expect. Luna: And speaking of things that keep the show going without ads — you know, a couple of dollars a month from listeners is genuinely what keeps this whole podcast ad-free. If you've gotten something out of walking through the economy with us, buy me a coffee dot com slash fexingo. Lucas: Yeah, it really makes a difference. Even five bucks helps cover hosting and transcription. We keep this show independent, and that's because of people like you. So thank you. Luna: Alright, back to the bond market. We've got this standoff: falling breakeven rates vs rising import costs. Which side is more likely to break? Lucas: Well, historically, the bond market has a pretty good track record at forecasting inflation over multi-year horizons. But tariff policy is a wild card because it's a direct supply shock. The 2018-2019 tariffs did show up in consumer prices, but they were smaller and more targeted. This new round is broader and comes with a more aggressive justification. Luna: And don't forget the delayed effect. The import price spike we're seeing now might take 6 to 12 months to fully pass through to shelves. So the breakeven rate could be underestimating the impact. Lucas: Exactly. The other thing to watch is the Fed's language. Kevin Warsh at the Fed has been homing in on key phrases in speeches — the market is parsing every word for signs of concern about trade-driven inflation. If the Fed starts sounding worried about tariffs, the breakeven rate could reverse quickly. Luna: So for the listener, the takeaway might be: don't assume low inflation expectations mean inflation is dead. The bond market could be right, but it could also be caught off guard. What's your call? Lucas: I think the most likely path is that headline CPI continues to drift lower over the next few months, but then we see a modest uptick in late 2026 and into 2027 as tariff costs hit. The breakeven rate might rise a bit from here, but not above 2.5 percent unless the tariffs expand further. The Fed will hold rates steady through year-end, watching to see if the import price shock is transitory or persistent. Luna: That feels like a reasonable middle ground. It's not a disaster scenario, but it's not the all-clear either. Lucas, anything else we should flag? Lucas: Just one more data point: the effective fed funds rate is still at 3.63 percent, flat since June. The Fed is in a holding pattern. But if the breakeven rate drops below 2 percent, that would signal serious recession risk, and you'd probably see rate cuts. Keep an eye on that number. Luna: Good advice. Thanks for breaking it down. Talk next time.