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 the yield curve has been inverted for about a year now, and the S&P 500 just hit another record high. If you're listening to that and thinking something doesn't add up, you're not wrong. Luna: It's kind of the classic 'this time is different' warning that makes everyone nervous. Lucas: Right. But the Fed is essentially saying, yeah, we see it, and we're not that worried. And I think the key to understanding why is that the curve is no longer just a pure signal about where the economy is headed. It's been distorted by a whole bunch of technical factors that have nothing to do with growth or inflation. Luna: Can you walk me through what's actually distorting it? Because I feel like every time I look at the 2s10s it's like 20 basis points, but nobody's panicking. Lucas: So the first thing is the Fed's own balance sheet. They're still running off Treasuries and mortgage-backed securities, which puts upward pressure on long-term yields. That's not a recession signal, that's just the mechanics of quantitative tightening. And then you've got the Treasury issuing a ton of debt to fund the deficit, which also pushes long yields higher. Luna: But isn't that exactly what inverts the curve? More supply at the long end, less demand, yields go up. Lucas: It should, but the curve's actually inverted, which means long yields are still below short yields. So what's pulling the long end down? That's the puzzle. And the answer is that you've got a huge amount of structural demand for long-duration assets from pension funds, insurance companies, and foreign central banks that just don't care about a few basis points of yield. They need duration to match liabilities. Luna: So it's like a supply and demand story where the demand side is super sticky. Lucas: Exactly. And that's why the term premium — the extra compensation investors demand for holding long-term bonds — has been compressed to almost nothing. In fact, it's been negative on and off for years. That's not a normal market outcome. It tells you that the market isn't pricing in much inflation or growth risk over the long run, which is actually a more dovish signal than the curve inversion itself. Luna: But the Fed's preferred inflation gauge just showed core prices at 3.3 percent annually. That doesn't scream 'no inflation risk' to me. Lucas: That's the tension. The breakeven rate on the 10-year is only 2.32 percent, which is actually below the Fed's 2 percent target when you adjust for the fact that it's a bit overstated. So the market is basically saying, inflation stays anchored, even though the latest data is still running hot. The Fed is looking at that and saying, okay, the curve inversion is telling us less about recession and more about this weird balance between supply and demand in the Treasury market. Luna: So you're saying the curve isn't broken, it's just... different. Lucas: Right. And there's even a chance that the curve could un-invert without a recession, just from the Fed cutting short rates while long rates stay put. That's actually what the market is pricing in. The fed funds rate is at 3.63 percent, and the futures market expects cuts over the next year. If that happens, the curve steepens, and people will say, 'See, the signal was wrong.' But it wasn't wrong; it's just that the signal got muddied. Luna: But can the Fed really cut rates with core inflation at 3.3 percent? That's above their target. Lucas: They can if they think the inflation is transitory or if the labor market cracks. And you've seen some softening: the unemployment rate ticked down to 4.1 percent, but payrolls actually shrank a bit in July. Job openings are down from 7.5 million to 7.3 million. So there's a deceleration. The Fed has a dual mandate, and if the labor market weakens enough, they might tolerate inflation running a bit above target for a while. Luna: So the curve is saying 'recession' but the data is saying 'maybe not yet.' Lucas: And that's the thing. Historically, an inverted curve has preceded every recession in the last 50 years, but the lead time is long and variable — anywhere from 6 to 24 months. We've been inverted for about a year. So if this signal is still valid, we'd expect a downturn at some point in the next 12 to 18 months. But a lot of economists argue that the signal is less reliable now because of the factors we just talked about: quantitative tightening, foreign demand, and the Treasury's massive issuance. Luna: And then you've got the Treasury General Account. There's been talk about Bessent tapping nearly a trillion dollars for bond buybacks. Does that change the calculus? Lucas: It's a big deal if it happens. The Treasury General Account has grown to around a trillion dollars because of the debt ceiling resolution. If they use that to buy back outstanding bonds, it would reduce the amount of duration the market has to absorb. That could push long yields down even further, steepen the curve, and maybe even un-invert it. It's not a monetary policy tool, but it has similar effects on the term premium. Luna: So is that a good thing or a bad thing? Lucas: It depends on your perspective. If you're the Fed, it helps you because it eases financial conditions without you having to do anything. If you're a bond market vigilante, it's a sign that the Treasury is trying to manipulate the market. But the reality is, it's just a cash management decision. The Treasury has the funds, and they can deploy them however they want. Luna: But aren't there doubters? I saw Druckenmiller is skeptical about Bessent's plans. Lucas: Druckenmiller is skeptical of a lot of things, and he's been right before. But his concern is more about the long-term fiscal picture — that the government is spending too much and eventually the bond market will revolt. That's a real risk, but it's not what's driving the curve right now. The curve is driven by the here and now: the Fed's balance sheet, the Treasury's issuance calendar, and that wall of money looking for safe assets. Luna: So if I'm a listener, what should I take away from all this? Lucas: That the yield curve is still worth watching, but it's not the simple crystal ball it used to be. You have to look at it alongside the breakevens, the term premium, and the actual economic data. And right now, the data is mixed but not recessionary. The real red flag would be if the curve started un-inverting because long yields spiked due to a loss of confidence in fiscal policy — that would be a different, more dangerous signal. Luna: That makes sense. So it's not just about the slope, it's about the why. Lucas: Exactly. And that's why the Fed is comfortable looking through it. They know the curve is distorted by things they can't control. So they're focusing on the data that matters: inflation expectations, labor market, and financial conditions. And on those, the picture is still relatively benign. Luna: If walking through the economy with us has made something click for you today, we should mention that what keeps this show ad-free is listener support. We don't have sponsors, we don't sell ads, and that's a choice. If you've gotten value out of these conversations, you can help keep them going by buying us a coffee — buy me a coffee dot com slash fexingo. Lucas: Yeah, and it genuinely makes a difference. Every little bit helps us keep doing the research and the interviews and the daily episodes. We're not a big media company, just two people who love talking about this stuff. Luna: And back to the curve — it's funny, because even though the Fed is downplaying it, the bond market is still sending a message. The 10-year Treasury yield is around 4.68 percent, which is actually quite high historically. So maybe the signal isn't that a recession is coming, but that the market is nervous about something else — maybe the deficit, maybe the Fed's next move. Lucas: Right, and that's the nuance. The level of long yields matters, not just the slope. A 4.68 percent 10-year is not a screaming buy for bonds; it's a sign that the market wants a higher risk premium. When you combine that with the inverted curve, it's like the market is saying, 'We're not sure about the future, but we're not panicking either.' Luna: So what would make you change your mind? What would be the thing you'd watch to say, 'Oh, now this is a real recession signal'? Lucas: I'd watch the 10-year breakeven rate. If that starts falling below 2 percent — or worse, below 1.5 percent — that would mean the market is pricing in an economic collapse and deflationary pressures. That's when the curve inversion becomes a true warning. Right now it's at 2.32, which is actually a sign of stability. So as long as breakevens stay anchored, I think the curve is more noise than signal. Luna: So the thing to keep an eye on isn't the yield curve itself, but inflation expectations. Lucas: Exactly. And that's where I'd put my money — or my attention, at least. If you're trying to read the economy's future, the curve is a starting point, but the real story is in the breakevens and the term premium. Those tell you what the market actually believes about the future, not just what a simple slope implies. Luna: Well, that's a useful lens for the next few months. It's a lot more nuanced than just 'inversion equals recession.' Lucas: And that's the takeaway. The Fed is ignoring the curve because they think it's broken. But we should keep watching it — just with better eyes.