Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Bond Market Is Ignoring Sticky Inflation
Transcript
- Lucas: Core PCE has been sitting above three percent for months. The Fed’s not cutting. And yet the ten-year Treasury yield has actually been drifting lower. So the bond market is basically saying, ‘I don’t believe the inflation.’ Luna: Yeah, that’s a pretty clear disconnect. I mean the ten-year was up near four point six percent back in April, and now it’s at four point four two. That’s not a huge move, but it’s the wrong direction if you think inflation is sticky. Lucas: Exactly. And we had the latest core PCE print at one hundred thirty point one, up again. Month after month it’s grinding higher. Normally that would push long-term yields up — higher inflation expectations, higher term premium. But instead, we’re seeing the opposite. Luna: Before we dive deeper, I just want to say — if you find yourself thinking about this stuff and it clicks, you’re exactly why we do this show. A small group of listeners already chips in monthly at buy me a coffee dot com slash fexingo, and that’s what keeps the podcast ad-free and independent. Lucas: Yeah, honestly it makes a real difference. It’s not about big pledges, just knowing people value the deep dive. So thank you to anyone who’s part of that. Luna: Absolutely. And speaking of the deep dive — Lucas, what do you think is driving that bond market calm? Lucas: So the key is to break the ten-year yield into two parts: the real yield and the breakeven inflation rate. The ten-year real yield is about two point one eight percent right now. That’s actually up from where it was a few months ago. So the bond market is demanding a higher real return — that’s consistent with a strong economy. Luna: Right, but the breakeven has been falling, right? It’s at two point two four percent now, down from around two point four percent back in March. Lucas: Exactly. So the entire drop in the nominal ten-year yield is coming from the breakeven side. In other words, bond traders are revising down their long-run inflation expectations even as current inflation stays hot. They’re betting the Fed’s tight policy will eventually work, or that some structural disinflationary force — like productivity gains or globalization — will reassert itself. Luna: That’s a pretty bold bet. Because if you look at the real economy, GDP growth just came in at two point one percent annualized for the first quarter, rebounding from near zero. And the jobs market is still adding payrolls — nonfarm payrolls hit one hundred fifty nine million. That’s not a recessionary backdrop. Lucas: No, it’s not. And that’s what makes this interesting. The bond market is pricing in a soft landing, maybe even a no-landing scenario, but with inflation coming down on its own. Historically, that’s rare. Usually you need a recession to wring inflation out. But the market seems to think the post-pandemic inflation was largely transitory in nature — just a much longer transitory than anyone expected. Luna: So are bond investors just more optimistic than the Fed? Or are they looking at different data? Lucas: I think they’re looking at the same data but weighting it differently. The Fed is focused on the actual inflation prints — core PCE at three point one percent, core CPI at three point three — and they’re cautious. But bond traders are forward-looking. They see that wage growth is stabilizing around four percent, productivity is picking up, and the labor force participation rate has been climbing. That combination can absorb wage gains without fueling price increases. Luna: And there’s also the global disinflation story. China is exporting deflation, energy prices have moderated despite the geopolitical noise — the ten-year breakeven has actually been remarkably stable around two point two to two point three percent for months now. Lucas: That stability is itself a signal. If bond traders really thought inflation was unanchored, the breakeven would be spiking. Instead it’s just sitting there. So the market’s message is: the Fed doesn’t need to cut rates urgently, but it also doesn’t need to hike. The current fed funds rate at three point six three percent is restrictive enough to gradually cool the economy. Luna: But if that’s true, then why are we seeing the yield curve still inverted? The two-year is at three point seven three percent, the ten-year is at four point four two — that’s actually a positive slope now, but barely. Earlier this year it was deeply inverted. Lucas: Great point. The curve has been normalizing, but it’s not steep. A steep curve would signal that the market expects strong growth and maybe higher inflation ahead. A flat curve says ‘we’re not sure.’ So the bond market is hedging its bets. It’s pricing in maybe one or two rate cuts over the next twelve months, but nothing dramatic. And that’s consistent with a view that inflation will drift lower without a crash. Luna: So what’s the risk to this view? I mean, if inflation stays sticky above three percent for another six months, the bond market would have to reprice, right? Lucas: Absolutely. The risk is that the disinflation we’re seeing is just a temporary lull. Remember, shelter inflation has been slow to come down, and services inflation is still elevated. If wage growth reaccelerates or if commodity prices spike — say, because of the situation in the Strait of Hormuz — then the breakeven could jump. And then the ten-year yield would spike, and the Fed would be under pressure to hike again. Luna: But the market seems to be shrugging off those risks for now. The VIX is low, credit spreads are tight, equities are near all-time highs — the S&P 500 at seventy five hundred. It’s like the macro regime has shifted to ‘Goldilocks.’ Lucas: Right, but Goldilocks regimes don’t last forever. The question is whether the bond market is correctly reading the tea leaves or just complacent. I tend to think the bond market is usually smarter than the stock market about inflation. Bonds have a better track record of predicting inflation turns. So I’d give them the benefit of the doubt, but I’m watching the breakeven closely. Luna: So if I’m an investor, what do I do with this? Do I trust the bond market’s inflation forecast and position for lower rates? Or do I hedge against a re-acceleration? Lucas: I think the prudent move is to recognize that the bond market is already pricing in a benign outcome. So there’s not a lot of value in simply going long Treasuries. The real opportunity might be in the real yield — TIPS are yielding over two percent, which is attractive on a historical basis. And if you’re worried about inflation re-accelerating, you can buy TIPS directly. That’s a way to get paid while you wait. Luna: And if the bond market is wrong and inflation stays high, then equities could get hurt because the Fed would have to tighten. So maybe a barbell of TIPS and cash makes sense. Lucas: Exactly. Cash is yielding over three and a half percent right now. That’s not nothing. You can wait for clarity. But the main takeaway from today is that the bond market is telling us it believes the inflation fight is essentially won, even if the data hasn’t confirmed it yet. And that’s a powerful signal, whether you agree with it or not. Luna: I think that’s a fair place to leave it. Thanks for the breakdown. Lucas: Thanks for digging into it with me.