Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the 10-Year Breakeven Rate Is Stuck at 2.23 Percent
Transcript
- Lucas: There's this one number that keeps popping up in my terminal and it's been basically glued to the same spot for weeks: the 10-year breakeven inflation rate, sitting at 2.23 percent. Luna: And that's the market-based expectation for average inflation over the next decade, right? Derived from the gap between nominal Treasury yields and TIPS yields? Lucas: Exactly. You take the yield on a regular 10-year Treasury — which today is about 4.48 percent — and subtract the yield on a 10-year TIPS, and that difference is what investors collectively expect inflation to be. And right now it's stubbornly flat at 2.23. Luna: So while core CPI is running around 3.3 percent and core PCE is above 3 percent, the bond market is basically saying 'yeah, we think that's temporary, long-run inflation is fine.' Lucas: That's the textbook interpretation. And the Fed loves that — they want inflation expectations anchored near their 2 percent target. But the question is: is the breakeven rate actually telling us something deep about where inflation is headed, or is it a distorted signal because of technical factors? Luna: I've heard people argue that TIPS have a liquidity premium that artificially depresses their yield and therefore inflates the breakeven. But what's the opposite case — that it's too low? Lucas: Right, so there are a couple of forces at play. On one hand, TIPS are less liquid than nominal Treasuries, so investors demand a premium to hold them, which pushes TIPS yields higher and the breakeven lower. That would mean the true inflation expectation is actually above 2.23. On the other hand, there's a flight to safety dynamic: when markets get jittery, investors pile into nominal Treasuries, compressing their yields and widening the breakeven. So the signal can get noisy. Luna: And we're in a pretty weird macro environment right now. The Fed is stuck at 3.63 percent on rates, the labor market is cooling — June payrolls came in at just 57,000 — and yet inflation is still sticky. So why isn't the breakeven reacting more? Lucas: That's the puzzle. I think part of it is that the market has a lot of faith in the Fed's credibility. Even if inflation stays elevated for another year, the consensus view is that the Fed will eventually bring it down. So the 10-year average doesn't budge. But there's also a mechanical issue: the breakeven is a forward-looking average, not a spot reading. It smooths out short-term noise. Luna: So a few months of core PCE at 3.4 percent doesn't move the needle on a 10-year average. But what would? What would break the breakeven out of this 2.2 range? Lucas: Probably a sustained upside surprise in inflation that the Fed doesn't push back against — or a major policy shift, like the Fed signaling it's willing to tolerate higher inflation for longer. Or, on the downside, a sharp recession that collapses inflation expectations. But for now, the market is in this equilibrium where the data is mixed enough that nobody's changing their long-run view. Luna: And it's not just the breakeven. Look at the yield curve: the 2-year yield is at 3.69 percent, the 10-year at 4.48, so we have a positive slope again after that long inversion. That's usually a sign that the market expects the Fed to cut or the economy to slow. But the breakeven staying put suggests that whatever slowdown comes, it won't be disinflationary enough to push inflation below target. Lucas: That's a really important point. A steepening yield curve combined with a flat breakeven is kind of a Goldilocks scenario: the market expects some easing, but not a collapse in inflation. And the Fed probably sees that as validation of their 'higher for longer' stance. They're not getting pressure from the bond market to cut aggressively. Luna: So if you're an investor, does this breakeven tell you to position for inflation hedging or not? Because 2.23 is pretty close to the Fed's target, but actual inflation is running hotter. Lucas: I think the honest answer is that the breakeven is one input, but it's not the whole story. If you look at other measures — like the Cleveland Fed's 10-year expected inflation from TIPS and surveys — they're also around 2.2 to 2.3. So the consensus is that inflation will moderate. But if you're worried about structural changes like deglobalization or fiscal dominance, you might want to overweight TIPS anyway, because the breakeven could be understating the risk. Luna: And there's also the elephant in the room: the Fed's quantitative tightening is still running, which could be affecting liquidity in the TIPS market. Less liquidity means bigger distortions. Lucas: Exactly. The Fed is still letting about $60 billion of Treasuries roll off its balance sheet each month, and while they paused the MBS runoff, the overall tightening is still draining reserves. That could be adding to the liquidity premium in TIPS and keeping the breakeven artificially low. So maybe the true expectation is closer to 2.5 or 2.6, which would be more consistent with current core PCE. Luna: That would actually make the breakeven less comforting for the Fed. If they think expectations are anchored at 2.23 but it's actually 2.5 because of a liquidity distortion, then they might be in a tighter spot than they realize. Lucas: Right, and that's the kind of nuance that gets lost when people just look at the headline number. The breakeven is a useful shorthand, but it's not a perfect thermometer. So when I see it flat at 2.23, I don't assume everything is fine — I ask what's being suppressed. Luna: So what's your takeaway for listeners who follow macro? Should they pay more attention to the breakeven or less? Lucas: I'd say pay attention, but don't treat it as a forecast. Use it as one piece of the puzzle alongside real rates, the yield curve, and actual inflation prints. If the breakeven starts to move decisively above 2.5 or below 2.0, that's a signal. But drifting in a 2.2 range is more of a 'wait and see' signal than a clear direction. Luna: And we're in that wait and see period now, with the Fed on hold and inflation data still mixed. The breakeven is basically saying 'I'll believe it when I see it' on both sides. Lucas: That's exactly right. And on that note, if walking through the economy with us has made something click — if this kind of conversation is useful — the way we keep the show ad-free and independent is listener support. You can find us at buy me a coffee dot com slash fexingo. It's a small way to keep these daily episodes going without any sponsors. Luna: Yeah, I love that we can do this without any commercial breaks. It makes the conversation flow better, and we get to go deeper on stuff like the breakeven mechanics. Lucas: Absolutely. And staying with that theme of market signals that don't quite line up — I think the breakeven is a perfect example of why you can't just look at one indicator. We'll keep watching it, but for now, it's telling us that the market is patient, even if the data isn't. Luna: So we'll circle back once we get July CPI and PCE data. If the breakeven finally breaks out of its range, that'll be a big deal. Lucas: Exactly. Thanks, Luna. And thanks to everyone listening. We'll be back tomorrow.