Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Two-Year Yield Is Falling Again
Transcript
- Lucas: So last episode we talked about why the two-year Treasury yield had been climbing even as the Fed held rates steady. Well, that trend has completely reversed over the past week. The two-year yield dropped about ten basis points in five days, now sitting at 3.69 percent. Luna: That's a pretty sharp move. What's behind the reversal? Lucas: A couple of things. The market is increasingly confident the Fed will cut rates this fall, despite headline inflation not fully cooperating. Fed funds futures are now pricing in a cut by the November meeting. Luna: But core PCE just ticked up again, right? To 130.1? That's the highest reading since April. Lucas: Exactly. On the surface, that's the wrong direction for the Fed. But the details matter. The month-over-month increase was driven by volatile components like airline fares and portfolio management fees. The core services excluding housing actually moderated. Plus, the ten-year breakeven inflation rate edged down to 2.20 percent. The market is looking through the headline. Luna: So the bond market is betting the Fed will look through it too. Lucas: That's right. And the interest on reserve balances is still at 3.65 percent, while the effective fed funds rate is 3.63. The two-year yield at 3.69 is essentially saying: the next move is a cut, and it's coming soon. Luna: Interesting. Meanwhile, Singapore just tightened policy in a surprise move because of rising oil prices. That seems like a different playbook entirely. Lucas: It does. But the Fed's mandate is domestic, and the US economy is showing enough cracks—consumer stress signals, a slight uptick in jobless claims—to make the case for insurance cuts. And you know, making sense of these contrasts is exactly why we do this show. If it's helped you understand the economy, consider supporting us at buy me a coffee dot com slash fexingo. Just a couple of dollars a month keeps us ad-free and independent. Luna: Absolutely. Every little bit helps us keep digging into these data points. Lucas: So back to the two-year yield drop. Let's look at what the IORB rate tells us about the Fed's comfort zone. The spread between IORB and the effective fed funds rate is only two basis points. That's tight. When the fed funds rate pushes above IORB, it signals reserves are getting scarce. The current narrow spread suggests the Fed has room to cut without disturbing the plumbing too much. Luna: But if they cut, wouldn't that push the fed funds rate below IORB? Or do they adjust IORB in tandem? Lucas: Great question. The Fed sets IORB as a floor for the fed funds rate. If they cut the target range, they would lower IORB by the same amount. So the relationship stays intact. The market sees that as a clean path to lower rates. Luna: So the two-year yield is just following that expectation? Lucas: Precisely. The two-year yield is the most sensitive to Fed policy expectations. When it drops below 3.70, it's basically voting for a cut. And this week's move came despite a strong GDP print for the second quarter—we got that revision up to 2.8 percent annualized. So the market is betting the Fed will look past that and focus on the cooler inflation trend and some softness in hiring. Luna: Let's talk about that softness. Initial jobless claims have inched up over the last month, right? Lucas: Yes, they've moved from the low 230,000s to around 245,000. Not a huge jump, but consistent with a modest loosening in the labor market. The Fed's own Beige Book from earlier this month noted that some districts saw slower hiring. That gives the doves ammunition. Luna: So the market is effectively saying: 'We trust the Fed will cut, even if the data is mixed.' Lucas: Right. And that trust is partly because Fed officials have been noncommittal. Chair Powell's press conference last month emphasized that they are data dependent but also noted that policy is restrictive. That open door is enough for markets to walk through. Luna: One concern though: if the market pre-empts a cut and financial conditions ease, that could re-ignite inflation. The Fed might then pull back. Lucas: That is the classic catch-22. The Fed wants to ease before it's too late, but if they signal it too early, the conditions they're trying to create just get undone. For now, the drop in the two-year yield is modest. It's not a full-blown easing cycle. It's a ten basis point move over a week. But it's a signal that the narrative has shifted from 'higher for longer' to 'cut coming soon.' Luna: And that shift happened even as the ten-year yield also fell, but not as much. So the curve steepened a bit. Lucas: Exactly. The two-year fell more than the ten-year, so the two-to-ten spread widened. A steeper curve is usually consistent with expectations of near-term easing and longer-term growth concerns. That's a lot of information packed into a few basis points. Luna: What about the dollar? Didn't that also weaken a bit this week? Lucas: It did. The dollar index slipped about 0.3 percent. That's correlated with lower short-term yields. A weaker dollar helps emerging markets and commodity prices, but the Fed doesn't target the dollar per se. Still, it's a feedback loop. Luna: So to sum up: the two-year yield is signaling a cut, core PCE ticked up but the market is dismissing it, and the Fed has the tools and the rhetoric to follow through. Lucas: That's the case. Of course, we have a CPI print and another PCE release before the November meeting. If those numbers come in hot, the two-year yield will reverse again. But as of today, the bond market is leaning toward an easing bias. Luna: And that's a big change from just a few weeks ago when the two-year was pushing 3.90. Lucas: Right. It just shows how quickly expectations can reset when the data gods deliver a mixed message. We'll be watching the July CPI release due next week to see if this trend continues. Luna: Good note to end on. Thanks, Lucas. Lucas: Thanks, Luna. Catch you next time.