Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Yield Curve Uninversion Is a Warning Signal
Transcript
- Lucas: The yield curve has been inverted now for over two years — the longest stretch since the 1970s. And for most of that time, the standard take has been: the curve is screaming recession, but the economy keeps chugging along. So either the curve is wrong, or the recession is delayed. Luna: Right, and now it's starting to uninvert. The 2-year/10-year spread went from negative 100 basis points early last year to about negative 25 basis points as of this week. That's a massive steepening. Lucas: It is. And here's the thing that a lot of people miss — historically, the curve doesn't signal recession while it's inverted. It signals recession when it comes back out of inversion. If you look at the last six times the 2-year/10-year turned positive after being inverted, a recession followed within roughly twelve months every single time. Luna: So the uninversion itself is the warning, not the inversion. That's a counterintuitive point that gets buried in a lot of the headlines. Lucas: Exactly. The inversion is the setup. The uninversion is the trigger. And the logic makes sense — the curve inverts because the market expects the Fed to cut rates in the future, which usually happens because the economy is weakening. By the time the curve normalizes, the Fed has started cutting, and the damage is already underway. Luna: So where are we now? The Fed is at 3.63 percent, they haven't cut yet. The labor market is starting to soften — we got 57,000 payrolls in June, unemployment ticked down to 4.2 percent but that was partly because people left the labor force. Lucas: That's the part that makes this episode different from the historical pattern. In past cycles, the curve often inverted for maybe six to eighteen months. This time we're past two years. The economy has absorbed higher rates for longer than anyone expected. So the question is whether the lag is longer, or whether this time really is different. Luna: What do you think the bond market is pricing in right now? The 10-year is at 4.48 percent, the 2-year at 4.23 percent — so the gap is 25 basis points. If we see that spread turn positive, that would be the moment. Lucas: It could happen within the next couple of months if the data continues to soften. The market is pricing in about two to three quarter-point cuts by year-end. If the Fed starts cutting, the short end will fall faster than the long end, and the curve will steepen further. That's the classic bear steepener — long-term rates stay high because of inflation fears, short-term rates drop because the Fed is easing. Luna: And the stock market is at all-time highs. The S&P 500 is at 7483. That's a weird disconnect — bond market pricing in weakness, equity market pricing in strength. Lucas: It's a classic late-cycle tension. Equities tend to peak before the recession actually starts, but they don't always peak before the curve uninverts. In 2000, the curve uninverted in early 2000, the S&P 500 peaked in March 2000, and the recession started in March 2001. In 2007, the curve uninverted in mid-2007, the S&P 500 peaked in October 2007, and the recession started in December 2007. So the peak can be very close to the uninversion. Luna: But this time we also have inflation still above target. Core PCE is at 2.6 percent or so. The Fed can't cut aggressively if inflation doesn't cooperate. That's a constraint that wasn't there in 2000 or 2007. Lucas: That's the wild card. If the economy slows and inflation stays sticky, the Fed is stuck. They can't ease enough to prevent a recession, but they also can't hold rates high forever without causing one. That's the stagflationary risk that people whisper about but don't want to say out loud. Luna: So let me ask you this — if you're a listener looking at their portfolio, what should they be watching? The 2-year/10-year spread hitting zero? Or something else? Lucas: I'd watch the 2-year yield specifically. If it starts dropping rapidly — say, fifty basis points in a month — that means the market is pricing in aggressive Fed cuts, which usually means they see something bad coming. Also watch jobless claims. They've been low — 215,000 last week — but if they start trending above 250,000, that's a red flag. Luna: And the breakeven inflation rate? The 10-year breakeven is at 2.23 percent, basically flat. That suggests the bond market doesn't see inflation surging or collapsing. It's just… stuck. Lucas: Stuck is the right word. The whole economy feels stuck. GDP growth is 2.1 percent annualized, which is fine but not great. Inflation is stuck above target. The Fed is stuck at 3.63. And the yield curve is stuck in this no-man's land between inversion and uninversion. The next few months will tell us whether we get the historical recession signal or whether this cycle truly breaks the mold. Luna: You know, speaking of things that keep going — this podcast keeps going because of listeners who chip in small amounts. It's not a huge thing, but if walking through the economy with us has made something click for you, a couple of dollars a month genuinely makes a difference. It's what keeps these episodes ad-free and independent. Lucas: Yeah, it's a small gesture that adds up. If you've gotten value from the show, you can support it at buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash fexingo. Even a few bucks helps keep the lights on. Luna: Totally. And we really appreciate it. Alright, back to the curve — Lucas, you mentioned the historical pattern. Is there any precedent for an inversion this long without a recession? Lucas: Not really. The longest inversion before this was in the late 1970s, and that ended with a double-dip recession. The only way this time is different is if the economy's structure has changed — more services, less manufacturing, less interest rate sensitivity. But that argument has been made before, and it hasn't held up. Luna: So you're in the camp that says a recession is coming, just delayed. Lucas: I think it's the prudent base case. The timing is uncertain, but the mechanics are pretty well established. When the short end of the curve falls faster than the long end, it's because the market expects the Fed to cut. And the Fed typically cuts because the economy is deteriorating. The uninversion is the market saying: 'we think the slowdown is real enough that the Fed will have to act.' Luna: And if the Fed doesn't cut? If inflation stays sticky and they hold at 3.63? Lucas: Then the curve could stay inverted longer, which would be even more unprecedented. But that would also mean higher real rates for longer, which historically is a recipe for a harder landing. Either way, the bond market is sending a message. The question is whether the stock market is listening. Luna: All right, something to watch in the weeks ahead. Thanks Lucas. Lucas: Thanks Luna. We'll keep an eye on it.