Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Yield Curve Un-inversion That Has Everyone Confused
Transcript
- Lucas: The yield curve has been inverted for something like 800 days now — the longest stretch in modern history. Every recession playbook says that's supposed to mean trouble. But this week, the curve started steepening in a way that has a lot of bond traders scratching their heads. Luna: And not the kind of steepening that comes from the Fed cutting. The short end is basically flat — the two-year yield barely budged. It's the long end that moved. Lucas: Right. The 10-year Treasury yield fell about 23 basis points over the last five trading days, from around 4.79% to 4.56%. The 30-year bond dropped a similar amount, to 5.06%. Meanwhile the two-year actually ticked up a fraction — 3.58%. So the spread between the two-year and the 10-year narrowed by roughly a quarter of a percentage point. Luna: That's a pretty aggressive move for one week. And it's happening while the Fed is sitting tight at 3.62% on the effective federal funds rate. No cuts, no hikes — just steady. Lucas: Exactly. So the typical explanation for a steepening curve is that the market is pricing in rate cuts ahead. But that would usually push the short end down faster than the long end. That's not what we're seeing. The long end is rallying hard — meaning bond buyers are piling into 10-year and 30-year debt, driving yields down — while the front end is essentially saying the Fed stays put. Luna: So what's driving the long end? Is it a flight to safety? Because we've got that Iran situation still rattling energy markets, consumer sentiment at a record low — people might just be buying Treasuries out of fear. Lucas: That's definitely part of it. The geopolitical premium is real. But there's another signal buried in the breakeven inflation rate. The 10-year breakeven — that's the market's implied expectation for average inflation over the next decade — ticked up to 2.40% this week, from 2.39%. It's tiny, but it's moving in the wrong direction if you're hoping inflation is sustainably heading back to 2%. Luna: So the bond market is basically saying: we're not convinced the Fed has won. Inflation expectations are sticky. And at the same time, growth fears are creeping in. Lucas: That's the uncomfortable cocktail. The real GDP growth number for the first quarter came in at an annualized 2.0% — that's up from a paltry 0.5% in the prior quarter, so the economy is accelerating. But nominal GDP is over $31.8 trillion, and inflation is still running hot in the CPI: April's reading was 332.4, up from 330.3 in March. Core CPI at 335.4. So we've got growth, but we've also got prices that refuse to cool. Luna: Stagflation lite, some people are calling it. Not the 1970s version with double-digit unemployment, but the uncomfortable middle where nothing breaks cleanly. Lucas: And the labor market data is reinforcing that narrative. The unemployment rate held at 4.3% in April — flat for the third month in a row. Nonfarm payrolls added 115,000 jobs, which is decent but not booming. JOLTS job openings fell to 6.866 million in March, down from 6.922 million. So the labor market is softening, but not collapsing. Luna: Average hourly earnings are up to $37.40 — that's a 2.7% year-over-year increase if you do the math. Not enough to offset CPI running above 3%. Lucas: Right. Real wage growth is still negative for a lot of workers. And that feeds into consumer sentiment, which hit another record low this month. People feel the pinch even if the headline GDP number looks okay. Luna: Which brings us back to the curve. If the economy is growing at 2% and inflation is sticky, why are long-term yields dropping? That's the part that doesn't fit the simple story. Lucas: I think the market is pricing in a higher probability of a policy mistake — either the Fed keeps rates too high for too long and tips the economy into recession, or some external shock forces a flight to safety. The bond market is basically saying: the future is more uncertain than the present, and I want the safety of a long-term government guarantee. Luna: And the Russell 2000 is up 3.4% this week — small caps are ripping. That's the opposite of a recession signal. Small caps typically get crushed when the market fears a downturn. Lucas: That's a great point. The Russell is up 3.4% in five days, while the S&P 500 is up only 1% and the Nasdaq is up 1%. So the rotation into small caps suggests investors are betting on a soft landing — that the economy keeps growing, but maybe at a slower pace, and that smaller companies will benefit from lower interest rates eventually. Luna: But lower rates aren't here yet. The Fed funds rate is still at 3.62%. The interest on reserve balances is 3.65%. So the cost of capital is high. Small caps are more sensitive to borrowing costs than mega-cap tech. Why are they rallying now? Lucas: Part of it might be valuation. Small caps have been left behind for years. The Russell is still well below its 2021 highs. And if the market starts to believe that the Fed is done hiking and the next move is a cut — even if it's months away — investors front-run that by buying the most beaten-down segments. Luna: Yeah, but the bond market isn't pricing in a cut anytime soon. The two-year yield actually went up this week. That's not a cut signal. Lucas: Correct. The two-year is basically saying the Fed stays on hold for the foreseeable future. So the small-cap rally might be more about relative value and a bet on economic resilience than about imminent monetary easing. Luna: Let's zoom out. The yield curve has been inverted since July 2022. That's almost four years. Every recession model that uses the spread has been flashing red for years. But we haven't had a recession. So either the models are broken, or this time really is different. Lucas: I think the models aren't broken — they're just calibrated to a different regime. The global savings glut, quantitative easing, the sheer size of the Treasury market — all of that has distorted the term premium. The inversion might be telling us less about imminent recession and more about the market's struggle to price a future with higher neutral rates. Luna: Which is what the Fed has been saying: the neutral rate might be higher than pre covid. If the neutral rate is around 3% or 3.5%, then a funds rate of 3.62% is basically neutral. That means the policy isn't restrictive — it's just not accommodative. Lucas: That's a huge shift from the ZIRP era. And if the neutral rate is higher, then the yield curve should be flatter at higher levels. The fact that it's steepening now — with the long end falling — suggests the market is not comfortable with that new neutral. It's almost like the bond market is saying: we'll believe the higher neutral rate when we see sustainable growth and inflation consistently at 2%. Luna: And the data isn't giving them that. CPI is still above 3%. The PCE price index is at 130.3, core PCE at 129.3 — both up. The 10-year breakeven is 2.40%. So inflation expectations are not well-anchored at 2%. Lucas: That's the crux of it. The bond market is sending a nuanced signal: we don't think you're going to cut, but we're not convinced inflation is dead, and we're nervous enough about the outlook to buy duration. That's not a screaming recession call — it's a hedging call. Luna: If walking through the economy with us has made something click — even just one of these connections — that's exactly the kind of value we try to bring every day. And listener support is what keeps this show ad-free and independent. If that's something you'd like to be part of, you can find us at buy me a coffee dot com slash fexingo. Lucas: It's a small gesture that goes a long way — helps us keep digging into these data points without worrying about sponsors. And we genuinely appreciate every single one. Luna: Alright, back to the curve. So if this steepening continues, what should we watch for? What would change the narrative? Lucas: I'd watch the 10-year yield closely. If it breaks below 4.4% — which is roughly where it was before the post-election selloff — that would be a strong signal that the market is pricing in a significant growth slowdown. If it stays in the 4.5% to 4.7% range, it's more of a consolidation. Luna: And what about the two-year? If that starts to drop, then we're talking about rate cut expectations. Lucas: Exactly. The two-year moving below 3.5% would be the clearest sign that the market expects the Fed to ease. Right now it's at 3.58%, so it's close. But it ticked up this week, not down. So the bond market is essentially saying: we're not there yet. Luna: Which brings us full circle. The curve is un-inverting, but not because the front end is falling — because the back end is rallying. That's not the typical pre-recession pattern. It's something new. Lucas: And that's why this is such a fascinating moment for macro. The old playbook doesn't quite fit. The economy is growing at 2%, inflation is sticky above target, the labor market is cooling but not cracking, and the bond market is pricing in more uncertainty than disaster. It's a market that rewards patience and punishes conviction. Luna: Maybe that's the real takeaway: humility. The curve is telling us that the future is foggy, and the best trade might be no trade at all. Lucas: Or at least, a trade that accounts for multiple scenarios. Because if there's one thing the last few years have taught us, it's that the bond market is usually right — just not on the timeline we expect.