Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed Is Watching the Two-Year Yield's Message
Transcript
- Lucas: So the two-year yield has been doing this little dance lately, first climbing, then pulling back, and the Fed is watching it with a kind of intensity that might seem odd unless you know what that number actually tells them. Luna: It's funny, because for most people, the two-year yield is just another number in the business section. But for the Fed, it's like a direct line to market expectations. Lucas: Right. And right now, the two-year is sitting around three point seven percent, which is essentially right on top of the effective fed funds rate of three point six three. That's not a coincidence. That's the market saying, we believe the Fed is done moving for the moment. Luna: But it wasn't like that a few weeks ago, right? I remember it was creeping up toward four percent at one point. Lucas: Yeah, it was. And that move higher was the market pricing in a real chance of a hike. The Fed has kept the door open to further tightening, and the two-year was reflecting that anxiety. Now it's come back down, which suggests that anxiety has faded, at least for now. Luna: So what changed? Was it the CPI report, or something else? Lucas: Part of it is the CPI report. July CPI came in a touch softer than expected, core inflation is still sticky but the overall trend is cooling. And you also have the ten-year breakeven rate falling to two point two four percent, which tells the Fed that long-term inflation expectations are well anchored. Luna: So the market is basically saying, the Fed is done, and maybe they'll even cut next year. Lucas: Exactly. And the Fed is listening to that signal, because the two-year yield is the market's best guess at where the fed funds rate will be in two years. It's not a forecast, it's a market-clearing price. And when it aligns with the current policy rate, it tells you that the market sees no dramatic moves ahead. Luna: But the Fed has been pretty clear they're not declaring victory on inflation yet. How do they square that with a market that's pricing in a pause? Lucas: That's the tension. The Fed wants to keep optionality. They don't want to pre-commit to a path, because the data could change. But they also rely on market signals like the two-year to gauge how their communication is landing. If the two-year starts moving against them, that's a sign their message isn't getting through. Luna: So what happens if the two-year starts climbing again? Does that force the Fed's hand? Lucas: Not necessarily force, but it would be a warning sign. A rising two-year yield means the market is pricing in higher rates down the road, which could be for a couple of reasons. It could be that inflation expectations are rising, or it could be that the market thinks the Fed will need to hike again. Either way, it tells the Fed that their communication isn't aligning with market reality. Luna: It's kind of like a feedback loop. The Fed talks, the market reacts, and the Fed reads the reaction to decide if they need to talk differently. Lucas: That's a great way to put it. And it's not just the level of the two-year, it's the shape of the yield curve. You've got the ten-year at four point seven percent, the two-year at three point seven, so the curve is steepening, which is actually a sign that the market expects the Fed to cut eventually. That's the opposite of an inverted curve, which we had for a long stretch and which often precedes a recession. Luna: So the steepening curve is the market saying, we think the next move is down, but not for a while. Lucas: Exactly. And the Fed is okay with that, as long as inflation keeps cooling. But if the data surprises to the upside, that steepening curve could invert again, and that would be a real problem. Luna: You know, this episode is making me think about how much of this is about trust. The Fed needs the market to trust that they'll do what they say. Lucas: It's the core of central banking, really. And that's why the two-year yield is such a powerful tool. It's a real-time measure of market trust. When it moves, it's the market voting on the Fed's credibility. Luna: Hey, if this kind of breakdown is useful to you, you might consider supporting the show. It's what keeps us going, and it's a small way to say this matters. If today was worth a coffee to you, that's the link, buy me a coffee dot com slash fexingo. Lucas: Yeah, we really appreciate that. It helps us keep doing what we do, bringing you these conversations without any ads. Luna: And honestly, it's the best way to tell us that we're not wasting your time. Lucas: So, back to the yield curve. We were talking about how the two-year is the market's expectation of the fed funds rate. But there's another nuance. The Fed doesn't just watch the two-year, they also watch the term premium, which is the extra compensation investors demand for holding longer-dated bonds. That's been compressed for a while, but it's starting to normalize. Luna: And when term premium rises, that pushes long-term yields up, which tightens financial conditions, which does some of the Fed's work for them. Lucas: Exactly. And that's why the Fed is so focused on the entire yield curve, not just the short end. The two-year gives you the policy signal, but the ten-year gives you the growth and inflation signal. And the fact that the ten-year is at four point seven percent while the two-year is at three point seven tells you the market expects growth to stay solid but not too hot. Luna: So if the two-year is the market's forecast for the Fed, what's the ten-year saying about the economy? Lucas: It's saying that the neutral rate, the rate that neither stimulates nor restricts the economy, is probably higher than it was before the pandemic. That's a big deal for policy. It means the Fed won't be able to cut rates as much as they used to in a downturn. Luna: That's a pretty big shift. And it's something the Fed has been slowly acknowledging in their projections. Lucas: Right, and the two-year will be the first to tell you when the market thinks the Fed has gotten the neutral rate wrong. If the two-year starts to diverge significantly from the fed funds rate, that's a signal that the market sees a policy mistake coming. Luna: So what would that look like? A two-year yield way above the fed funds rate would mean the market expects hikes, and way below would mean cuts. Lucas: Exactly. And right now, we're in this sweet spot where the two-year is just a few basis points above the fed funds rate. That's the market saying, we think the Fed is in the right place. But that can change quickly, especially with something like a geopolitical shock or a surprise in the jobs data. Luna: And we just had that headline about the Iran war risk. That could send oil prices up and mess with the inflation picture. Lucas: That's exactly the kind of thing that could push the two-year up. If oil spikes and inflation expectations rise, the market will start pricing in a higher path for rates, and the two-year will move. The Fed would then have to decide whether to talk it down or let it be. Luna: So the two-year is almost like a canary in the coal mine for the Fed. Lucas: It really is. And that's why you see Fed officials mention it so often in speeches. It's not just a market indicator, it's a communication tool. They use it to see if their message is landing. Luna: It's a little ironic that the Fed, which sets the shortest of short-term rates, spends so much time looking at a two-year yield. Lucas: Yeah, but that's the thing, the two-year is the shortest maturity that's actually a market rate. The fed funds rate is an administered rate, set by the Fed. The two-year is set by millions of traders. So it's the market's most direct say on policy. Luna: So when we see the two-year at three point seven, and the Fed has been saying they're in no rush to cut, that's the market agreeing with them. Lucas: For now. But the Fed knows that can change on a dime. And that's why they're so careful about their language, because they don't want to trigger a big move in that yield that they'd have to walk back. Luna: It's a delicate dance, but it sounds like the two-year is the music. Lucas: And right now, the music is pretty calm. But the Fed is listening for any change in tempo.