Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Yield Curve's Message
Transcript
- Lucas: So the ten-year Treasury yield is sitting near four point six seven percent, and the two-year is at three point seven three. That's a spread of almost ninety basis points. Not long ago, people were screaming about an inverted curve. Now it's steepening at a pace that has the Fed's attention. Luna: And that's the opposite of what you'd expect if the market thought a recession was imminent, right? Historically, a steep curve signals growth ahead. Lucas: Exactly. But the twist is that this steepening is happening while the Fed's effective rate is pinned at three point six three, and inflation expectations are drifting down. The ten-year breakeven is at two point two two percent, down slightly from last week. So the long end is falling in nominal terms, but the real rate is actually the thing they're obsessed with — and that's what we're going to dig into today. Luna: So when you say real rate, you mean the nominal yield minus expected inflation, right? Lucas: Yes. And the real rate is what the Fed actually controls over the medium term. If the nominal ten-year is four point six seven and the breakeven is two point two two, that implies a real yield of roughly two point four five percent. That's high by historical standards, and it's telling you that monetary policy is restrictive, maybe more than people think. Luna: But if the economy is slowing — we just saw that weak ADP number, only forty-four thousand private jobs added in July — why would the real rate stay so high? Lucas: That's the puzzle. The market is pricing in more rate cuts, but the long end isn't cooperating because term premium is elevated. There's a lot of supply of Treasuries, and foreign buyers are being selective. So the curve is steepening partly because the short end is falling on expected cuts, but the long end is sticky. Luna: And that creates a conundrum for a Fed that wants to ease but also needs to keep financial conditions tight enough to bring inflation to target. Lucas: Exactly. And this is where Kevin Warsh's comments earlier this week matter. He used the phrase 'real rate' repeatedly, which is a tell. He's signaling that they're watching this measure, not just the nominal fed funds rate. Luna: You think he's trying to set expectations that they won't cut as aggressively as the market hopes? Lucas: I think so. If the real rate is already restrictive, and inflation is cooling, then the nominal rate can stay higher than we've been used to. That's a shift from the pre-pandemic era, where the Fed was fighting to get inflation up. Now they're fighting to keep it down, and the real rate is the weapon. Luna: But the curve steepening also reflects a vote of confidence in the economy. If the market truly expected a recession, you'd see the long end falling faster than the short end, which would flatten or invert the curve. Lucas: Right. And that's why the steepening is actually a positive signal in some ways. But it's not a clean signal because of the supply story. And the Fed is in a tough spot: they want to ease, but they don't want to reignite inflation expectations. The breakeven at two point two two is below their two percent target on core, so they have room, but it's fragile. Luna: It feels like we're at a pivotal moment for the Fed's credibility. If they cut too soon, they risk letting inflation expectations drift. If they wait too long, they could choke off the recovery. Lucas: Exactly. And that's what makes this episode so crucial. You know, if walking through the economy with us has made something click for you, we'd love it if you considered supporting the show on buy me a coffee dot com slash fexingo. A couple of dollars a month genuinely keeps these episodes ad-free and helps us keep doing this deep-dive work. Luna: Yeah, listener support really does make a difference. It's a small way to say this content matters to you. Lucas: And we're back to the curve. So let's get into the specifics: the two-year yield has actually been falling, from around four point zero seven percent a week ago to three point seven three now. That's a big move in a short time. The market is pricing in at least two cuts by year-end. Luna: But the ten-year has only edged down slightly. So the spread is widening, which suggests the market is betting on cuts but also on a decent growth outlook. Lucas: Exactly. And the breakeven at two point two two is actually a bit below the core CPI trend. The core CPI for June was three three six point one, down slightly from the prior month. So nominal inflation is cooling, but the real rate is still high because the nominal long yield is being held up by term premium and supply. Luna: And what does that mean for the average person? Mortgages, car loans, credit cards — those are tied to longer-term yields, not the fed funds rate. Lucas: That's the key. Even if the Fed cuts, if the ten-year stays elevated, borrowing costs won't fall much. That's why the Fed cares so much about the long end. And that's why they're watching the real rate so closely. It's not just about the nominal funds rate; it's about the whole curve. Luna: So when Warsh talks about the real rate, he's really talking about the transmission mechanism. If the long end is sticky, the Fed's policy isn't as accommodative as the short rate suggests. Lucas: Exactly. And that's why some members of the FOMC are pushing for a more patient approach. They want to see if the elevated real rate is doing the work of taming inflation without needing deeper cuts. But others are worried about the lag effect — the weak ADP number suggests the labor market is cooling, and they don't want to overshoot. Luna: What would overshooting look like? If the real rate stays too high for too long, we could see unemployment start to rise more sharply. Lucas: Right. And the Fed has a dual mandate, but they've made it clear they're focused on inflation first. Yet with the July jobs report showing only forty-four thousand private jobs, that's a red flag. The market is starting to question whether the Fed is behind the curve on labor. Luna: And the manufacturing survey from earlier this week showed inflation worries 'worse than pandemic era,' adding to the pressure. That's a direct signal that businesses are still feeling pricing pressure, even if the headline CPI is cooling. Lucas: Yeah, that's a great point. The Fed is looking at a mixed bag: cooling inflation in some sectors, but sticky costs in others. And the real rate is the lens through which they're interpreting all of it. If the real rate is too low, inflation could reignite. If it's too high, the economy could stall. Luna: So where does that leave us? What should we expect from the next FOMC meeting? Lucas: I think they'll hold steady in September, but the statement will likely signal that they're prepared to act if the labor market weakens further. The real rate narrative gives them cover to wait, because they can argue that the current stance is restrictive enough. Luna: But if the ten-year stays above four point five percent, that real rate is still going to bite. Maybe they need to see the curve flatten again before they feel comfortable cutting. Lucas: That's a really sharp observation. The curve is the market's way of telling the Fed what it expects. And right now, it's expecting cuts — but it's also telling them that long-term yields are anchored by something else. That something else is the real rate, and it's the key signal to watch in the coming months. Luna: So for anyone watching the Fed, the real rate is the number to track, not just the fed funds rate. Lucas: Exactly. And we'll be here to decode it for you. That's it for today. Thanks for listening.