Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Yield Curve Steepening Is Rattling the Fed
Transcript
- Lucas: The ten-year Treasury yield just hit four point six eight percent. That's up more than ten basis points in the last week alone, and it's the highest reading we've seen since before the Fed started cutting rates last year. Luna: And at the same time, the ten-year breakeven rate — the market's expectation for future inflation — actually ticked down to two point two six percent. So nominal yields are rising, but inflation expectations are falling. That's an unusual combination. Lucas: Exactly. And it's the kind of move that the Fed can't ignore. If this was worth a coffee to you, honestly, the link to support the show is buy me a coffee dot com slash fexingo. It keeps us ad-free and digging into data like this. Luna: Yeah, we love doing this, and listener support makes it possible. So thanks if you've ever chipped in. Lucas: Alright, back to the bond market. The rise in nominal yields alongside falling inflation expectations means real yields — the inflation-adjusted return — are climbing. The implied real yield on the ten-year is now around two point four percent. That's getting close to the interest on reserve balances, which is at three point six five percent. Luna: So the bond market is effectively tightening financial conditions on its own, even though the Fed hasn't moved the fed funds rate from three point six three percent. Does the fed see that as a problem or a help? Lucas: It's a double-edged sword. On one hand, higher real yields slow down borrowing and spending, which helps the Fed fight inflation. On the other hand, if the yield curve steepens too quickly, it can disrupt mortgage markets and put stress on banks' balance sheets. And we're already seeing some of that stress in the regional banking data. Luna: There was a big speech from Fed governor Kevin Warsh last week where he kept using three specific phrases: 'patient', 'data-dependent', and 'prepared to adjust'. Fed watchers are parsing those as a signal that the committee is uneasy about the bond market's message. Lucas: Right. 'Prepared to adjust' is the key one. It suggests the Fed is ready to change its balance sheet runoff pace or even tweak the interest on reserves rate if the backup in yields starts to pose a systemic risk. Remember, the Fed's balance sheet is still shrinking by about sixty billion dollars a month. That runoff is absorbing a lot of the excess reserves that banks rely on for liquidity. Luna: And when reserves get scarce, short-term rates can spike above the fed funds target. We've seen that happen before in September 2019. Could that repeat if the yield curve keeps steepening? Lucas: It's a real risk. The interest on reserve balances is supposed to be a floor for the fed funds rate, but if reserves fall too low, banks start hoarding cash and the fed funds rate can drift higher. Right now, the effective fed funds rate is exactly at three point six three, right at the top of the target range. That's fine. But if the ten-year yield keeps climbing, it might pull short-term rates up with it. Luna: So the steepening curve isn't just about long-term growth expectations. It's also about liquidity in the banking system. And the Fed has to weigh whether to slow the runoff to keep the plumbing working. Lucas: Exactly. And that's why Warsh's language matters. He's essentially telegraphing that the Fed is watching the yield curve as an input to policy, not just an output. If the ten-year goes to five percent, which isn't that far given it's already at four point six eight, the conversation shifts from 'should we cut?' to 'should we stop shrinking the balance sheet?' Luna: And that's a huge shift. Most market participants are still thinking about when the next rate cut comes. But the bond market might be forcing the Fed to delay cuts or even pause the runoff. Lucas: Precisely. Look at the five-year yield at four point four three percent. That's up three percent in just five days. The intermediate part of the curve is moving fast, and that's where a lot of corporate borrowing and mortgage rates are pegged. So financial conditions are tightening rapidly without the Fed lifting a finger. Luna: Is there any historical precedent for the Fed reacting to yield curve steepening in real time? I'm thinking of Operation Twist back in 2011, but that was a different context. Lucas: Good comparison. In 2011, the Fed sold short-term securities and bought long-term ones to flatten the curve. But today, the Fed is in runoff mode, not active reinvestment. They'd have to either stop the runoff entirely or restart some purchases, which would reverse quantitative tightening. That's a much bigger step than what they did in Operation Twist. Luna: And politically, stopping the runoff would be seen as a dovish move. With inflation still above target — core PCE is at two point six percent on the latest reading, though we'll get June data next week — it might be hard for the FOMC to justify. Lucas: That's the tension. The bond market is telling them that the economy may be slowing more than the data shows. But the inflation data, especially for services, remains sticky. The Fed's own Beige Book noted that consumer spending is holding up, but that the World Cup gave bars and restaurants a temporary boost. Once that fades, we could see a sharper slowdown. Luna: So the steepening yield curve might be a canary in the coal mine for a growth scare, rather than an inflation scare. And the Fed has to figure out which one it is before making its next move. Lucas: Exactly. And that's why every word from Warsh and other FOMC members is being parsed so closely. If they start emphasizing 'prepared to adjust' more, markets will take that as a signal that the Fed is willing to respond to the curve. But if they stick with 'patient,' the sell-off could continue. Luna: So for now, the ball is in the bond market's court. The next big data point is the July employment report, but even before that, the yield curve will keep telling its story. Lucas: And we'll keep watching it. Thanks for joining us.