Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Ignores the Yield Curve Now
Transcript
- Lucas: So for months now, everyone from Wall Street strategists to your cab driver has been pointing at the yield curve and saying, recession's coming. And yet here we are in late August 2026, the curve is still deeply inverted, and the economy is still growing. What gives? Luna: Right, and by 'deeply inverted' we mean the ten-year Treasury is yielding less than the two-year. As of today, the ten-year is at 4.74 percent, and the two-year is at 3.71 percent. That's a hundred basis points of inversion. Lucas: Exactly. And historically, that kind of inversion has been the single most reliable recession indicator we have. It predicted every recession since the 1960s. But here's the thing — the curve has been inverted for over a year now, and the economy just keeps chugging along. Real GDP grew at 1.5 percent annualized in the second quarter, and unemployment actually ticked down to 4.1 percent. Luna: So is the yield curve broken? Or is the economy just different this time? Lucas: That's the $40 trillion question. And I think the answer is that the yield curve is still a good signal, but we've changed the mechanics of the bond market so much that the signal is a lot fuzzier than it used to be. Let me unpack that. Lucas: First, let's talk about what the yield curve actually measures. When the two-year yield is higher than the ten-year, it usually means investors expect the Fed to cut rates in the future because they see a slowdown coming. That's why inversions precede recessions. Luna: But this time, the inversion is happening in a world where the Fed is at 3.63 percent, the two-year is at 3.71, and the ten-year is at 4.74. Wait, that's not inverted. Lucas: Hold on, I think I mixed up the numbers. Let me re-check. The ten-year is at 4.74, the two-year is at 3.71. So the ten-year is actually higher than the two-year. That's a positively sloped curve, not inverted. Luna: Oh, so the curve is not inverted? But I thought we were talking about inversion. Lucas: Right, so let me correct myself. The yield curve is no longer inverted. It used to be inverted for a long stretch, but now it's steepened back to a normal, positive slope. The ten-year at 4.74 is a hundred basis points above the two-year at 3.71. That's actually a steep curve. Luna: So the recession signal has disappeared. Does that mean we're in the clear? Lucas: Not necessarily. And this is the interesting part. The curve is steepening, but not because the Fed is about to cut. It's steepening because of something else entirely: the Treasury's massive borrowing needs and the Fed's quantitative tightening. Lucas: Let's break it down. The U.S. government just crossed $40 trillion in debt, and Secretary Bessent has been trying to manage that by issuing a lot of long-term debt. That's pushing the ten-year yield up. At the same time, the Fed is shrinking its balance sheet — quantitative tightening, or QT — which reduces demand for longer-dated bonds, also pushing those yields higher. Luna: So the steepening is more about supply and demand, not about growth expectations. Lucas: Exactly. And that's why the old recession signal has lost its power. In the past, an inverted curve meant investors were pricing in a Fed that would have to cut aggressively because of a recession. That would make long-term yields fall below short-term yields. Now, we have a situation where the Fed is on hold, and the bond market is being driven by fiscal policy and central bank balance sheet operations. Luna: And there's also that Treasury buyback program that Bessent announced. The headline said it could be more than $4 billion. What's that all about? Lucas: Yeah, that's a fascinating twist. The Treasury is actually buying back some of its own debt. That's a tool they haven't used much in decades. The goal is to improve liquidity in the market, especially in older, off-the-run bonds. But here's the kicker: while the Treasury is buying back some bonds, they're also issuing a ton of new debt. So the net effect is still more supply, keeping upward pressure on long-term yields. Lucas: And that's why we're seeing this weird combination: a steepening curve, but not because the economy is booming. Instead, it's because the government is borrowing like crazy, and the Fed is stepping back as a buyer. That's a recipe for higher term premiums — the extra compensation investors demand for holding long-term debt. Luna: So what does that mean for the Fed? They're supposed to be watching the yield curve for clues about the economy. But now the curve is telling them more about fiscal policy than about growth. Lucas: Right, and that's a real headache for the Fed. They have to separate the signal from the noise. The steepening curve might look like a vote of confidence in the economy, but it's actually just reflecting the government's borrowing spree. So the Fed can't read it the old way. Lucas: But here's the thing — there is still a signal embedded in the curve about what the market thinks about future Fed policy. For example, the fact that the two-year yield is at 3.71, only slightly above the fed funds rate of 3.63, suggests that the market expects the Fed to hold steady for a while. If they thought a recession was coming, they'd be pricing in aggressive cuts, and the two-year would be much lower. Luna: So the short end is saying 'no recession,' but the long end is saying 'watch out for inflation.' Lucas: Exactly. And that's reflected in the ten-year breakeven inflation rate, which is at 2.34 percent — right around the Fed's target. So the market isn't expecting a big inflation breakout, but they are demanding a higher term premium because of all the supply. Luna: But wait, could the steepening be a sign that the bond market is warning about something else, like a loss of confidence in the U.S. to manage its debt? Lucas: That's the elephant in the room. When you have $40 trillion in debt and a Treasury Secretary talking about buybacks to calm markets, it does raise questions about how sustainable this all is. But so far, the market is still buying U.S. debt, and the dollar hasn't collapsed. So it's not like a crisis of confidence, but it's something to watch. Lucas: And the Fed is stuck in a tricky spot. They can't just ignore the bond market, but they also can't read it the way they used to. So they're probably going to remain data-dependent, watching inflation and jobs, rather than relying on the yield curve as a standalone indicator. Luna: And you know, this also ties into why they keep talking about the budget deficit. Because the deficit is driving the supply of Treasuries, which in turn is affecting the term premium and the whole shape of the curve. Lucas: Exactly. So when we talk about the Fed watching the budget deficit, it's not just about fiscal sustainability. It's about how the deficit affects the transmission of monetary policy. If long-term yields are being pushed up by supply, that can tighten financial conditions without the Fed doing anything. And that's a big deal. Luna: So, in a way, the yield curve is still telling us something about the economy, but it's a more complex story than 'inverted equals recession.' Lucas: Right. And I think that's the takeaway here. The yield curve is not broken, but its meaning has changed. We have to look at the components — the short end tells us about Fed expectations, the long end tells us about supply and term premium. And that's actually a richer picture than we used to get. Luna: So if an investor is looking at this curve, what should they do? Is it a sign to buy long-term bonds, or to be cautious? Lucas: I'd say it's a sign to be cautious about making big bets on the direction of the economy. The curve is sending mixed signals. The short end says the Fed is on hold, the long end says the government's borrowing is going to keep putting upward pressure on yields. So if you're betting on a recession, you might be wrong. If you're betting on higher inflation, you might be wrong too. This is a time for diversification and not over-interpreting any single indicator. Luna: And speaking of not over-interpreting, you know what I appreciate about this show? We get to break down these complex ideas without all the noise. And if today's conversation helped you make sense of the bond market, that's exactly what we're here for. If you ever feel like supporting what we do, there's a link on our site — buy me a coffee dot com slash fexingo. Just a small way to keep us ad-free and independent. Lucas: Yeah, and it does go a long way. But back to the curve — one more point I want to make is that the Fed is going to be watching the term premium very closely. If it keeps rising, that could tighten financial conditions and slow the economy, which is something they might have to respond to. But if it stabilizes, they can stay on hold. So that's the key metric to watch in the coming months. Luna: So the next time you see a headline about the yield curve, remember it's not as simple as 'inverted means recession' or 'steepening means growth.' It's a reflection of fiscal policy, central bank policy, and market expectations all at once. Lucas: Exactly. And that's the kind of nuance we need right now. Thanks for listening, and we'll see you tomorrow.