Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Ten-Year Yield Won't Break Five Despite Sticky Inflation
Transcript
- Lucas: The ten-year Treasury yield is sitting at 4.50 percent as of this afternoon. That's down about one and a half percent over the past five days. And core inflation is still running hot — the April CPI came in at 332.4, up from 330.3 in March. Consumer sentiment just hit a fresh record low last week. So the obvious question is: why isn't the bond market pushing yields higher? Luna: It does feel like a disconnect. Inflation is sticky, the consumer is gloomy, and yet the long end of the curve is actually rallying a bit. What's the bond market seeing that the headlines aren't? Lucas: Well, let's start with the numbers. The ten-year breakeven inflation rate — that's the market's implied expectation for average inflation over the next decade — is at 2.40 percent. That's up just a hair from 2.39 last week. So the market does expect inflation to stay above the Fed's 2 percent target, but not dramatically so. Luna: Right, 2.40 is still within shouting distance of 2 percent. It's not like the breakeven is screaming 3 or 4 percent. Lucas: Exactly. And compare that to the effective fed funds rate, which is 3.64. The real yield on the ten-year — nominal yield minus breakeven — is about 2.10 percent. That's actually a pretty attractive real return for a risk-free asset. So the bond market is saying: we're getting paid well enough to wait for inflation to come down. Luna: But what if inflation doesn't come down? We've had a few months now where core CPI and core PCE have been creeping up. The core PCE price index is at 129.3, up from 128.9 in February. That's not a huge jump, but it's the wrong direction. Lucas: That's the tension. The bond market is essentially pricing in a soft landing — or at least a 'no landing worse than this' scenario. The curve is not inverted anymore in the classic sense: the two-year is at 3.58, the ten-year at 4.50, so there's a positive slope. That typically means the market expects the Fed to cut at some point, not hike. Luna: And the Fed hasn't moved. The funds rate has been flat at 3.64 since April. Chair Warsh has been very clear that they're not in a hurry. But the bond market seems to believe that patience will pay off. Lucas: Right. The market is betting that the current level of rates is restrictive enough to eventually cool the economy. And there are some signs that might be true. The small-cap index, the Russell 2000, is up over 6 percent in the last five days — that's a big move. Small caps are more sensitive to domestic economic conditions and borrowing costs. If they're rallying, maybe the market thinks rate cuts are coming. Luna: But consumer sentiment is at a record low, partly because of the Iran war and energy prices. That should weigh on growth, right? Unless the market is looking past that and seeing a post-conflict recovery. Lucas: Could be. The geopolitical risk premium is real, but it's also hard to price. If you look at the ten-year yield, it's been range-bound between roughly 4.30 and 4.70 for weeks. It's not breaking out. So the bond market is basically saying: we see the risks, but we're not panicking. Luna: What would break that calm? What would push the ten-year above 5 percent? Lucas: A supply shock would do it. If oil prices spike further because of the Iran conflict, that feeds directly into inflation expectations. Or if core CPI comes in at 0.4 percent month-over-month again, the market might start pricing in a hike, not a cut. That would push long-term yields higher. Luna: So the bond market is basically assuming the status quo holds — inflation stays moderately above target, the Fed stays on hold, and the economy muddles through. That feels like a fragile equilibrium. Lucas: It is fragile. And that's why the yield curve is still relatively steep for this stage of the cycle. The two-year yield is 3.58, the ten-year is 4.50. That's almost 100 basis points of term premium. Normally, when the market expects a recession, the curve flattens or inverts. Here, it's steep because the market expects the Fed to cut, but not because of a crash — just because inflation will slowly normalize. Luna: That's the soft landing narrative. But the consumer sentiment numbers are screaming recession. There's a real disconnect between hard data like CPI and soft data like sentiment. Lucas: That's a classic problem for the Fed. They tend to focus on hard data — inflation, employment, GDP. But sentiment can become a self-fulfilling prophecy. If consumers stop spending because they're gloomy, that does hit growth. And then the bond market might be too optimistic. Luna: If walking through the economy with us has made something click — or if you just appreciate a show that doesn't have ads every five minutes — listener support is what keeps this going. You can find us at buy me a coffee dot com slash fexingo. It's a simple way to help us keep the conversation ad-free. Lucas: Yeah, we really appreciate that. And it lets us focus on the data without any outside noise. Luna: So back to that disconnect. If the bond market is wrong, and inflation doesn't come down, what happens? Lucas: Then the Fed would be forced to consider a hike. Chair Warsh has said repeatedly that they'll do what's necessary, but the political pressure is intense. A hike right now would be very controversial. But if the data forces their hand, they'll move. And if they hike, the ten-year could easily break 5 percent. Luna: And if they don't hike, and inflation stays sticky, the bond market might do the work for them — higher long-term yields tighten financial conditions without the Fed lifting a finger. Lucas: That's the vigilante scenario. The market forces the Fed's hand by pushing yields up. We've seen that play out in other countries. But so far, the U.S. bond market has been remarkably orderly. The ten-year is at 4.50, not 5.00. The question is whether that calm lasts. Luna: What's your best guess? Six months from now, where are we? Lucas: I think the bias is for yields to drift higher, but not dramatically. Maybe 4.75 to 5.00 by year-end, unless we get a clear disinflation signal. The Fed is stuck between a rock and a hard place — inflation above target, but growth slowing. They'll probably hold through the summer, and then we'll see. Luna: So the bond market's current calm might just be the eye of the storm. Lucas: Could be. But for now, the ten-year is saying: I'm okay at 4.50. And that's a pretty important signal for the entire economy — mortgages, corporate debt, equity valuations. It's worth watching every day.