Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Inverted Yield Curve Again
Transcript
- Lucas: The yield curve has been inverted for over two years now — the longest stretch since the 1970s. And it's getting attention again because the gap between the 2-year and the 10-year Treasury is still sitting at minus 74 basis points. That's not a new low, but it's stubbornly deep. Luna: I've been hearing more people say the curve is 'broken' as a recession signal. But the Fed doesn't seem to be ignoring it. Lucas: Right, and that's the thing. If you look at the 3-month to 10-year spread, which is the part of the curve the Fed watches most closely, it's flattened to just 12 basis points. That's almost no inversion. So the message from the short end is different from the belly of the curve. Luna: Why does that matter for the Fed? They've held rates steady since June, and the fed funds rate is at 3.63 percent. The market is pricing in cuts, but the Fed keeps pushing back. Lucas: Exactly. The inversion tells you the market expects rates to come down. But the Fed's dot plot from June showed they see rates staying around 3.6 percent through year-end. That's a disconnect. The curve is essentially saying, 'We don't believe you.' Luna: And the longer that disconnect persists, the more pressure it puts on banks, right? Because they borrow short and lend long. Lucas: That's the mechanism. Banks pay depositors short-term rates and earn longer-term yields. When the curve is inverted, that spread turns negative. It's called a 'negative carry.' Regional banks in particular have been feeling that pinch. The KBW Regional Banking Index is down about 8 percent in the last month alone. Luna: So the Fed can't just ignore the curve because it's telling them something about financial stability, not just the inflation outlook. Lucas: Precisely. And there's another layer here — the term premium. Normally, investors demand extra yield for holding longer-term bonds because of inflation and duration risk. But right now, the term premium is actually negative. That means investors are willing to accept lower yields on long bonds because they're so convinced rates will fall. That's a massive bet on a dovish Fed. Luna: Is that historically unusual? Negative term premium? Lucas: It's rare. The last time we saw sustained negative term premium was in the 2010s after the financial crisis. And before that, you have to go back to the 1970s — which is exactly when we last had an inversion this long. So the history is repeating in an uncomfortable way. Luna: And the 10-year breakeven inflation rate is at 2.25 percent — basically right where the Fed wants it. So inflation expectations are anchored, but the curve is still inverted. That's odd. Lucas: It is odd. Normally, if inflation expectations are stable, the curve should be upward sloping. The fact that it's inverted suggests the market sees a growth problem, not an inflation problem. That's why the Fed can't just dismiss it as noise. Luna: Speaking of what the market sees — the S&P 500 is at 7,475, which is basically flat over the last five days. The Nasdaq is down a bit. The Russell 2000, which is more sensitive to domestic growth, is down 2 percent. Small caps are feeling the rate anxiety. Lucas: Yeah, and that ties back to the curve. Small caps are usually more leveraged, more reliant on bank lending. When the curve is inverted, banks tighten lending standards. The Fed's Senior Loan Officer Survey from May showed that about 30 percent of banks reported tighter standards for commercial and industrial loans. That's a direct channel from the curve to Main Street. Luna: So if the Fed cuts rates, does the curve un-invert? Or does it get worse? Lucas: That's the million-dollar question. If the Fed cuts because inflation is under control, the short end falls, and the curve could steepen. That's the 'soft landing' scenario. But if they cut because the economy is weakening, long rates might fall even faster, and the inversion could persist or deepen. Markets are pricing in about 75 basis points of cuts by December. That's a lot. Luna: And the jobs data from last week — payrolls of just 57,000 — certainly didn't argue against cuts. But the Fed has been cautious. Lucas: Yeah, Chair Powell said after the June meeting that they need to see 'more good data' on inflation before moving. But the curve is telling them the market thinks they're too slow. The risk is that if they wait too long, the inversion starts to cause real damage to bank balance sheets and credit availability, and then a recession becomes self-fulfilling. Luna: That's the old line about the Fed tightening until something breaks. But here, the break might be the curve itself. Lucas: Right. And one more thing: the 30-year Treasury yield is at 5.07 percent, up about 2 percent in the last five days. That's the long end actually rising, even while the front end is inverted. That usually means investors are demanding more compensation for holding long-duration bonds — whether for inflation uncertainty, fiscal concerns, or just supply. The Treasury is issuing a lot of debt. Luna: So the long end is steepening independently. That could actually help the curve normalize without the Fed having to cut. Lucas: Exactly. If long yields rise while short yields stay flat, the inversion naturally resolves. But that would mean higher borrowing costs for the government, for mortgages, for corporates. Not exactly painless. Luna: You know, as we talk about the bond market and all the data we're digging into, I realize this is exactly the kind of analysis that you don't get on mainstream financial TV. They'd spend two minutes on it and move to the next headline. Lucas: Yeah, and that's the whole point of this show. We deliberately don't run ads, so we can spend as long as we need on a topic like the yield curve and actually explain the mechanics. No commercial breaks interrupting the signal. Luna: Right. And if you find this kind of deep dive valuable, you can support that choice to keep it ad-free — it's really simple: buy me a coffee dot com slash fexingo. That's it. Lucas: And it does make a difference. Because our only incentive then is to make the show better, not to chase ad revenue. Okay, back to the curve. There's actually a specific FOMC meeting coming up at the end of July, and the market will be watching to see if they adjust the language on the yield curve at all. Luna: What's interesting is that the Fed doesn't target the yield curve directly, but they do monitor financial conditions. And the curve is a big part of that. Lucas: Exactly. The Fed's own Financial Stability Report mentions the yield curve as a risk factor. They know that prolonged inversion can create unintended consequences. One thing I'm watching is the overnight reverse repo facility — that's been draining slowly, but it's still at about 400 billion. That's liquidity that could come into the system and steepen the curve if banks start lending more. Luna: But that's more of a technical factor. The real driver is what the Fed does with the fed funds rate. Lucas: Right. And the market is pricing in a cut at the July meeting — about 25 basis points. But if you look at the fed funds futures, the probability is only about 40 percent. So it's not a done deal. The data between now and then — especially the June CPI report, which comes out next week — could tip the scales. Luna: And core CPI was at 336.1 in May, up from 335.42. That's a month-over-month increase of about 0.2 percent. If that trend continues, the Fed might feel comfortable cutting. Lucas: Exactly. A 0.2 percent month-over-month core CPI reading is consistent with the Fed's target. But they need to see it sustained. And the curve is essentially saying, 'We think you'll get there soon.' Luna: So the curve isn't broken — it's just sending a very specific signal about where the market thinks rates are headed. And the Fed is listening, even if they're not acting yet. Lucas: That's the takeaway. The yield curve is still one of the best leading indicators we have for interest rate expectations. It's not a perfect recession predictor — nothing is. But when you see an inversion this persistent, it's worth paying attention. Two years and counting. Luna: And we'll know more in a few weeks when the FOMC meets. But until then, the curve is doing its job. Lucas: Exactly. And we'll keep watching it.