Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Ten-Year Breakeven Rate
Transcript
- Lucas: So the ten-year breakeven inflation rate just ticked down to 2.31 percent, from 2.33 a week ago. That's a small move, but it's the most interesting number in the bond market right now. Luna: I was going to say, that's not exactly a headline-grabbing change. But you're right, it's worth digging into. What does it actually tell us? Lucas: Well, the breakeven rate is the market's collective guess at what inflation will average over the next ten years. It's derived from the gap between regular Treasury yields and Treasury Inflation-Protected Securities, or TIPS. When that gap narrows, it means investors are expecting less inflation. Luna: So a dip from 2.33 to 2.31 is basically the market saying, 'we're a little less worried about inflation.' But isn't the Fed's target 2 percent? Why does 2.31 still seem high? Lucas: Right, the Fed's target is 2 percent, but that's for the PCE price index, which tends to run a bit below CPI. The breakeven is for CPI, which has averaged around 2.3 percent over the last decade. So 2.31 is actually pretty much in line with the historical norm. Luna: Got it. So it's not too hot, not too cold. But why are we seeing this dip now, especially when core PCE just ticked up last month? Lucas: That's the puzzle. Core PCE, the Fed's favorite inflation gauge, rose to 130.7 in July, up from 130.34. That's a modest increase, but it's still running above the breakeven rate. So you have a divergence: the actual data is a bit sticky, but the market's long-term expectations are cooling. Luna: Which one should the Fed trust more? The hard data or the market's expectations? Lucas: The Fed watches both, but expectations are arguably more important. If the market believes inflation will stay around 2.3 percent for the next decade, that belief can become self-fulfilling. Wage negotiations, pricing decisions, even long-term contracts all get influenced by where people think inflation is headed. Luna: So a dip in breakevens could actually give the Fed some cover to stay patient on rate cuts. Because it's a sign that inflation expectations are anchored. Lucas: Exactly. And that's why the Fed is watching this number so closely. The effective fed funds rate is sitting at 3.63 percent, with interest on reserve balances at 3.65. If breakevens stay put, the Fed can argue that policy is restrictive enough without having to hike again. Luna: But does the two-year yield matter more than the ten-year breakeven for the Fed's near-term decisions? We've talked about the two-year a lot on this show. Lucas: Sure, the two-year is more about the expected path of policy over the next couple of years. The breakeven is more about the long-run inflation regime. Both are important, but the breakeven tells you whether the Fed's credibility is holding up. Luna: And right now, that credibility seems solid. But let me play devil's advocate: what if the breakeven is low because the market is worried about a recession? Deflation risk, not just lower inflation? Lucas: That's a good point. If investors were really worried about deflation, the breakeven would be much lower, maybe below 1 percent. At 2.31, it's still comfortably above the Fed's target. So it's not sending a deflation alarm. Luna: Okay, so it's a Goldilocks number. But is 2.31 too low for comfort? I mean, the Fed might worry that inflation expectations are drifting below target, which could make it harder to hit 2 percent. Lucas: That's a real concern. If the breakeven falls too far, say below 2 percent, it would suggest the market doubts the Fed can get inflation back up. But 2.31 is still a healthy buffer. And look at the five-year breakeven—it's been drifting lower, but the ten-year is holding firm. That flattening of the expectations curve is actually a good sign. Luna: Meaning the market thinks any inflation is short-term, not a long-term problem. So the Fed can focus on the here and now. Lucas: Exactly. And that brings us to something we should mention. You know, we make this podcast specifically because we think understanding these signals matters. We deliberately keep it ad-free, so if you've been following along and finding it useful, you can support that by buying us a coffee. It's buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep us independent and focused on the stuff that actually matters. No pressure, but it helps. Lucas: Alright, back to the breakevens. So where do we go from here? I think the key is watching how the next few CPI prints come in. If they start to align with the breakeven's signal, the Fed can afford to stay on hold well into next year. Luna: But if core PCE keeps ticking up, like it did last month, could that force the Fed to reconsider? Maybe even talk about hiking again? Lucas: Possibly, but the Fed has been clear that they're data-dependent. One month doesn't make a trend. And the breakeven is telling them that long-run expectations are stable. That's powerful. Luna: So the bond market is basically giving the Fed a vote of confidence. But what about the stock market? The S&P is up, but the small-cap index is down over two percent this week. Is that a disconnect? Lucas: There is some divergence. Small caps are more sensitive to borrowing costs and economic slowdowns. The Russell 2000 fell 2.1 percent over five days, while the S&P 500 held up. That could be a sign that investors are rotating toward quality, or it could just be a sector-specific story. Luna: Right. But if the Fed stays patient and breakevens stay low, that should be good for risk assets overall, right? Lucas: Generally, yes. But there's always a risk that the Fed stays too patient and inflation reaccelerates. That's why they're watching the breakeven so closely. It's like a canary in the coal mine. Luna: So, in plain English: the ten-year breakeven is signaling that the Fed has credibility, but it's not a green light to ease aggressively. Lucas: Exactly. And that's the nuance we like to bring. It's not just about the headline CPI number or the next jobs report. Sometimes the most important data is quietly sitting in the bond market, telling you what investors really believe. Luna: And that's what makes this show different. We dig into the stuff that doesn't make the evening news. Lucas: Absolutely. So next time you see a headline about inflation, remember to check the breakeven. It might just tell you where we're really headed. Luna: And if you want to support us in that mission, you know where to find us. Buy me a coffee dot com slash fexingo. But honestly, just listening is enough. Lucas: Thanks for having this conversation with us. Until next time, keep your eyes on the data, not just the headlines.