Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / Why the Yield Curve Is Flashing 1970s Signals Again
Transcript
- Lucas: So, Luna, you've probably seen the headline that the yield curve has been inverted for over a year now, but here's the number that should actually stop you: the gap between the ten-year and the two-year Treasury has now been negative for longer than any stretch since the late 1970s. We're talking about a signal that's been flashing red for over 400 days straight. Luna: That's a long time. But I thought the yield curve was supposed to be a recession predictor, and we keep seeing GDP growth at one and a half percent annualized. That's weak, but it's not a recession. Lucas: Right, and that's exactly the puzzle we want to unpack today. The old playbook says an inverted curve means a recession is coming within twelve to eighteen months. We're past that window, and the economy is still chugging along, albeit slowly. So either the signal is broken, or we're in a different kind of regime — and I think the answer is the latter. Luna: Okay, so what's different about this time? Because I remember in 2019, the inversion happened and everyone panicked, and then the pandemic hit anyway, so it kind of looked like the curve was right. Lucas: True, but that was a classic inversion driven by the Fed hiking rates into a slowdown. This time, we've got a peculiar mix: core PCE inflation is still running at 3.3 percent as of July, real growth is below trend, but unemployment is at 4.1 percent and job openings are still above 7 million. That combo doesn't look like the lead-up to a typical recession. Luna: So the curve might be telling us something else. What's the bond market actually saying? Lucas: The bond market is saying it doesn't believe the Fed's path. The long end is stuck because investors think inflation will stay above target for years, while the short end is high because the Fed is still trying to fight that inflation. That's why the curve is inverted — it's not predicting a recession, it's pricing in a policy mistake. Luna: A policy mistake? As in, the Fed is keeping rates too high for too long? Lucas: Exactly. And there's a twist this time: the Treasury is actively trying to manage the curve with bond buybacks. We've been talking about Bessent's plan to tap the Treasury General Account, which could be close to a trillion dollars, to fund these buybacks. That's unprecedented in modern times. Luna: Wait, so the Treasury is basically buying back its own debt to steepen the curve? How does that work? Lucas: The idea is to buy back shorter-dated securities and push investors into longer maturities. That would push long-term yields down and short-term yields up, un-inverting the curve. But there's a catch: the market is skeptical. Just this week, Stanley Druckenmiller joined the doubters saying Bessent's bond ploys will fail. And with the Fed still running quantitative tightening, you have a buyer's strike on longer maturities. Luna: So the Treasury is trying to do what the Fed used to do with Operation Twist, but without the Fed's balance sheet behind them. Lucas: Precisely. And that's why the yield curve inversion is so stubborn. In the late 1970s, you had inflation expectations unanchored, and it took Paul Volcker to break the back of inflation by sending short-term rates to 20 percent. The curve inverted then because long-term investors didn't believe inflation would stay that high, so they were willing to buy long bonds at lower yields. That inversion actually preceded the recessions of 1980 and 1981-82. But today, the inversion is different because inflation is lower, but still persistently above target. Luna: And we've got that 10-year breakeven inflation rate sitting at 2.32 percent, which is not crazy high. So the market expects inflation to come down, but maybe not to the Fed's 2 percent target. That's a kind of 'higher for longer' scenario. Lucas: That's exactly right. And look at what gold is doing — it's up over the past week, and it's been rallying all year. The spot price is above four thousand six hundred dollars an ounce. Gold thrives when investors lose faith in the ability of central banks to manage inflation without crushing growth. That's the stagflation hedge. Luna: So you're saying the yield curve inversion and gold rally are two sides of the same coin — the market is skeptical of the policy path, but it's not expecting a recession, just a prolonged period of stagnation with inflation. Lucas: Exactly. And that's a very 1970s vibe. But before we go deeper into the historical parallels, I want to take a quick moment to note that we're able to have these conversations without any ads, and that's because of listeners like you. If you've been getting something out of these episodes, you can support us at buy me a coffee dot com slash fexingo. It's a simple way to keep us independent and ad-free, and we appreciate it. Luna: Yeah, we really don't want to interrupt the flow with ads, and it's been great that we can do that. So if you're listening and you enjoy this, that link is there if you want to help out. Lucas: Now, back to the 1970s. In that decade, you had two oil shocks, food price spikes, and wage-price spirals. Today, we don't have the same triggers, but we have supply chain disruptions from trade wars, and we have a labor market that's still tight in certain sectors. The JOLTS report for June showed job openings at 7.36 million, down from 7.54 million. That's a slowdown, but it's not a collapse. Luna: So the labor market is cooling, but slowly. That's more like 'stagflation-lite' than the 1970s, right? Lucas: Right. And that's why the bond market is not pricing in a deep recession. The five-year forward inflation expectation is around 2.3 percent, which is not terrible. But the curve is still inverted because the Fed is stuck. They can't cut rates aggressively because inflation is still above target, and they can't hike because growth is weak. So they're maintaining a restrictive stance, and that keeps short-term yields high. Luna: And the long end? With the Treasury doing buybacks, you'd think they'd be able to push long-term yields down. But the market is skeptical. What's the resistance? Lucas: Part of it is the sheer size of the Treasury's financing needs. We've got a $40 trillion debt mountain, and the government is still running large deficits. Even with buybacks, you have a wall of supply coming. And the Fed is not buying. In fact, they're shrinking their balance sheet. So who's going to buy all these long bonds? That's the question. Luna: That's a good point. And it ties into what we saw last week with the Canadian dollar sliding over trade war fears. If trade tensions escalate, that could push up import prices and keep inflation sticky, which would make the Fed even more cautious. Lucas: Exactly. Trade policy is another supply-side shock that feeds into stagflation dynamics. And China is also building hedges against sanctions, which could alter the demand for Treasuries. All of this adds to the uncertainty in the bond market. Luna: So is there any scenario where the curve un-inverts without a recession? Lucas: Yes, if the Fed manages to engineer a soft landing, meaning inflation falls to 2.5 percent or so while growth stays around 2 percent. Then they could start cutting rates, which would bring the short end down, and the curve would steepen. But that's a narrow path. The more likely scenario, given the data, is a prolonged period of 'stagnation with inflation', which keeps the curve inverted for a while longer. Luna: And that's what the gold market is telling us. Investors are hedging against that scenario. Lucas: Right. So when you see the yield curve inversion lasting this long, don't automatically assume a recession is coming. Instead, ask what the bond market is really saying: that the Fed's policy is stuck, and that the risk is more of a 'muddle through' economy with inflation running above target. That's the 1970s echo we should be listening to. Luna: That's a useful way to think about it. So next time we see an inverted curve, we should look at the broader context — inflation expectations, Fed policy, and what gold and the dollar are doing. Lucas: Exactly. And that's what we'll be tracking in the coming months. The question to keep in mind: will Bessent's bond buybacks actually move the needle, or will the market continue to call his bluff? We'll see.