Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The 10-Year Breakeven Is Dropping What the Bond Market Is Saying
Transcript
- Lucas: So here's something that jumped out from today's data: the 10-year breakeven inflation rate has dropped to 2.29 percent. That's down from 2.32 just yesterday and it's the lowest we've seen since, I think, early April. Luna: Right, and that's interesting because the CPI is still running at 4.2 percent year-over-year. So the bond market is basically saying inflation will come down hard over the next decade, but the consumer is still feeling it. Lucas: Exactly. The breakeven is the difference between the yield on a nominal 10-year Treasury and the yield on a 10-year Treasury Inflation-Protected Security, or TIPS. It's the market's expectation for average annual inflation over the next ten years. And it's been dropping steadily since the wholesale price report came out on June 11th. Luna: That report showed wholesale prices rose 1.1 percent in May, way above expectations, driven by a surge in energy. So if anything, you'd think inflation expectations would tick up, not down. Lucas: That's the puzzle. But I think the bond market is looking past the energy spike. Oil prices have actually pulled back a bit in the last week — some of that geopolitical risk premium coming out after the Iranian tanker news. And the UK economy shrank in April, which is a reminder that global demand is softening. Luna: So the breakeven is more about the demand side than the supply side. The energy surge is a supply shock, but the bond market is betting that it will fade, and that underlying demand is weak enough to keep inflation in check. Lucas: Right. And look at the real yield. The 10-year TIPS yield — that's the real rate — is around 2.14 percent. That's actually quite high by historical standards. It means the bond market thinks monetary policy is restrictive enough to cool the economy. Luna: But the Fed funds rate is at 3.63 percent, and the 10-year nominal is at 4.43. So the yield curve is still inverted, but less so than it was. The two-year is at 4.17, the ten-year at 4.43 — that's a positive spread of about 26 basis points. A few months ago it was deeply inverted. Lucas: Yeah, the curve un-inverting is usually a sign that a recession might be coming, not that we're out of the woods. But the breakeven dropping suggests the market thinks the Fed will eventually get inflation under control without causing a huge downturn. Or at least that's the optimistic read. Luna: The more pessimistic read is that the breakeven is being dragged down by a flight to safety. If investors are worried about global growth — UK contraction, Iran tensions — they pile into Treasuries, which pushes yields down and compresses the breakeven. Lucas: That's a real possibility. The 10-year nominal yield has fallen about 6 basis points in the last five days. If it's a safe-haven move, then the breakeven drop might overstate how much inflation expectations have really declined. Luna: And that matters for the Fed. They've been saying they need to see sustained evidence that inflation is moving toward 2 percent before they cut rates. If the breakeven is artificially low, they might ignore it and keep rates higher for longer. Lucas: Yeah, and speaking of the Fed, the effective fed funds rate is at 3.63 percent, right in line with the target range. The interest on reserve balances is 3.65, so they're keeping things tight. The next CPI and PCE prints are going to be crucial. Luna: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these episodes possible. Lucas: Yeah, it's a small group, but it keeps the whole thing ad-free and lets us dig into data like this without worrying about sponsors. If walking through the economy with us has made something click, that's the place to help out. Luna: So back to the breakeven — one thing I'm watching is the relationship with job openings. JOLTS just jumped to 7.6 million in April, up from 6.9 million. That's a huge increase. If the labor market is still that tight, wage pressure could keep core inflation sticky. Lucas: That's the other side of the coin. The breakeven says inflation will cool, but the job market says demand for workers is still strong. Average hourly earnings are up to $37.50, growing about 4.2 percent year-over-year. Productivity would need to be really strong to absorb that without price increases. Luna: So the bond market is betting on a soft landing: inflation comes down, the Fed cuts rates, no recession. But the data so far is mixed. The economy added jobs, but the unemployment rate stayed at 4.3 percent. Initial jobless claims ticked up to 229,000. Lucas: Right, and real GDP growth annualized was only 1.6 percent in the first quarter. That's not booming. So maybe the bond market is right that demand is softening. But the CPI and PCE are still elevated — core CPI at 336.1, up from 335.4. That's not falling fast. Luna: One way to square the circle is to look at the composition of inflation. The wholesale price surge was mostly energy. Core wholesale prices might be more moderate. The breakeven might be picking up on that — that the headline spike is transitory. Lucas: And the Fed has been emphasizing core PCE, which is at 129.6, up from 129.3. It's still moving up gradually. But the 10-year breakeven is now below core PCE inflation, which is unusual. It suggests the market thinks core PCE will fall below 2.3 percent over time. Luna: That's a pretty aggressive bet. The Fed's own projections from the last dot plot had inflation staying above 2 percent through 2027. So either the bond market is more optimistic, or it's pricing in a recession scenario where demand collapses. Lucas: I lean toward the recession scenario being a factor. Look at the UK — GDP shrank 0.1 percent in April. If that's a leading indicator for the US, then the breakeven drop could be a warning. The bond market might be saying 'we think the economy is going to slow enough that inflation won't be a problem.' Luna: But the Fed doesn't want to cause a recession. They're stuck. If they cut rates now, inflation could re-accelerate. If they hold, the economy might tip over. The breakeven is basically the market's vote on which risk they think is bigger. Lucas: And right now, the vote is that inflation risk is receding. But I'm not fully convinced. The JOLTS jump, the wage growth — those are real. And the wholesale price number was ugly. If the next CPI comes in hot, the breakeven could reverse quickly. Luna: So we're watching the June CPI data, due out in a few weeks. And the PCE for May, which comes out later this month. Those will be the real tests. Lucas: Exactly. For now, the bond market is sending a clear signal: they expect inflation to cool. But signals can be noise. We'll know more when the hard data comes in.