Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / How the 10-Year Breakeven Rate Signals Inflation's Next Move
Transcript
- Lucas: So the June CPI print lands next week, and everyone's bracing for another hot number after May's 4.2 percent. But there's this quieter number that's actually been moving in the opposite direction, and I think it tells a really interesting story about where inflation is headed — or at least where the bond market thinks it's headed. Luna: You're talking about the breakeven inflation rate, right? The one derived from TIPS versus nominal Treasuries? Lucas: Exactly. The 10-year breakeven rate — which is basically the market's expectation for average inflation over the next decade — it's been drifting lower. As of yesterday, June 16th, it sits at 2.29 percent. Down from 2.32 percent just a week earlier. Luna: So on the surface, that sounds like good news. Market thinks inflation will average just over 2 percent over ten years. That's basically the Fed's target. Lucas: Right. But here's the puzzle. That number has been falling even as headline CPI keeps coming in hot. The May CPI was 334.0 on the index, up from 332.41 in April. Core CPI, which strips out food and energy, hit 336.1. That's not cooling quickly. So you've got this divergence: actual inflation running above 4 percent, but the forward-looking market measure drifting toward 2 percent. Something has to give. Luna: So which one is right? Is the bond market being too optimistic, or is the CPI data misleading us about the trend? Lucas: That's the million-dollar question. Let's unpack how the breakeven rate actually works, because I think a lot of people hear the term and assume it's some kind of official forecast. It's not. It's just a math problem. You take the yield on a 10-year nominal Treasury note and subtract the yield on a 10-year TIPS, which is inflation-protected. The difference is the breakeven inflation rate. Luna: So if the nominal yield is 4.5 percent and the TIPS yield is 2.21 percent, the breakeven is 2.29 percent. That's the inflation rate at which both investments would deliver the same real return. Lucas: Exactly. If actual inflation comes in above 2.29 percent over those ten years, TIPS outperform. If it comes in below, nominal Treasuries win. So the breakeven is the market's collective guess, priced in by millions of transactions. Luna: And right now that guess says 2.29 percent. But CPI is at 4.2. That's a big gap. Is the market just wrong? Lucas: It could be. But there are a few explanations. First, the breakeven rate reflects expectations over ten years, not just the next few months. So even if inflation stays elevated for another year, the market might expect it to taper off significantly after that. The Fed's tightening cycle is already pushing rates up — the effective fed funds rate is at 3.63 percent as of May. That should eventually cool demand. Luna: But we've been hearing 'eventually' for a while now. Inflation has been sticky. Energy prices are still a wild card, especially with the Iran situation. Wholesale prices jumped 1.1 percent in May, largely on energy. Lucas: That's the risk. The breakeven rate could be underestimating how persistent inflation will be. But there's another angle: maybe the breakeven is actually sending a signal about real economic growth. When investors are worried about a recession, they tend to flock to Treasuries, which pushes nominal yields down. But TIPS yields also fall, and the spread can narrow. A falling breakeven can sometimes reflect growth fears more than inflation confidence. Luna: So you're saying the 2.29 percent might partly be a 'slowdown premium' — investors betting that a weaker economy will cool inflation on its own. Lucas: Precisely. And that ties back to something we've seen in other indicators. The 10-year breakeven has been declining since April, even as CPI prints stayed hot. If you look at the trajectory, it's almost as if the bond market is front-running a slowdown that hasn't fully shown up in the jobs or spending data yet. Luna: So for the average listener, what does this mean practically? If the breakeven is right, inflation will average around 2 percent over the next decade. If it's wrong, we could be looking at persistently higher costs. Lucas: Yeah, and that has real implications. Your wage negotiations, your rent increases, your investment portfolio — they all depend on what inflation does over the long haul. If you're a retiree living on fixed income, a 2 percent world is very different from a 4 percent one. Luna: And speaking of the long haul, one thing I appreciate about this show is that we don't have to interrupt the conversation with ads. We get to just follow the thread wherever it goes. Lucas: That's by design. We deliberately keep Inflation Explained ad-free because we think this stuff matters enough to deserve an uninterrupted discussion. If you find value in that approach, and you'd like to support it, there's a simple way — buy me a coffee dot com slash fexingo. No pressure, no perks, just a way to keep the show free for everyone. Luna: Yeah, it's a small gesture that makes a big difference for us. And it means we can keep digging into data like this breakeven puzzle without worrying about ad-reads. Lucas: Alright, back to the breakeven. So we've got this divergence. How should listeners interpret it? I think the key is to not treat the breakeven as a crystal ball, but as one input. It's a market-based measure, which means it's constantly updating with new information. Luna: And it has a decent track record. Historically, the 10-year breakeven has been a reasonably good predictor of actual inflation over the subsequent decade, though not perfect. Lucas: Right. Studies have shown that the breakeven rate has a root mean squared error of about 1 percentage point. So it's not precise, but it's directionally useful. And right now, the direction is gently downward. Luna: But we should also mention that breakeven rates can be distorted by technical factors. For example, during the 2020 pandemic, the breakeven plunged to near zero, partly because of a liquidity crunch in TIPS markets, not because inflation expectations collapsed. Lucas: Great point. So we shouldn't over-interpret the daily wiggle. But the trend over the past two months is worth noting. The 10-year breakeven peaked around 2.5 percent in April and has been sliding since. That's a meaningful shift. Luna: Let me play devil's advocate. What if the breakeven is actually too high? What if we're heading into a deflationary shock? Lucas: Deflation seems unlikely given the current backdrop, but the UK economy just shrank 0.1 percent in April, and the ECB just hiked rates for the first time since 2023. Global growth is shaky. If that spills over into the US, demand could cool faster than expected, pulling inflation down. The breakeven would be reflecting that risk. Luna: So the breakeven is like a thermometer for the bond market's fever — but you have to know what kind of fever you're measuring. Lucas: Exactly. Is it inflation fear or growth fear? Right now, the bond market seems to be saying: we think the Fed's medicine will work, and maybe we'll even get a bit too much cooling. But the CPI data says the patient is still running a temperature. Luna: So what's your take? Which side do you lean toward? Lucas: I think the market is probably pricing in too much disinflation, given how sticky services inflation has been. But I also think the Fed is serious about keeping rates high until inflation is tamed. The fed funds rate is at 3.63 percent and the interest on reserve balances is 3.65 percent — that's restrictive. Eventually, that will bite. Luna: So maybe the truth is somewhere in between. Inflation stays above 2 percent for another year or two, then settles around 2.5 percent. That would put the breakeven in the right neighborhood. Lucas: That's plausible. And it's worth watching the breakeven in the coming weeks, especially after the next CPI print. If it jumps, that tells you the market is revising up its inflation outlook. If it stays low or falls further, the market is doubling down on a slowdown. Luna: Either way, it's a number worth knowing. Not as a prediction, but as a temperature check on what the smartest money in the room is thinking. Lucas: And that's the thing about inflation — it's never just one number. It's a web of signals. The CPI, the breakeven, the PCE, the wholesale prices — they all tell different parts of the story. Our job is to piece them together. Luna: And we'll keep doing that. Next time, maybe we'll dig into the wholesale price jump — 1.1 percent in May. That energy surge isn't going away. Lucas: Absolutely. Stay curious, everyone.