Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / What the Yield Curve Is Saying About the Economy Right Now
Transcript
- Lucas: The yield curve has inverted, then un-inverted, steepened, flattened — and most people I talk to just throw up their hands. But if you actually look at what the curve is doing right now, it's telling a pretty coherent story. Luna: Coherent in what sense? Because a lot of headlines make it sound like the curve is sending mixed signals. Lucas: I think the confusion comes from people treating inversion as a one-size-fits-all recession predictor. What matters is the shape and the direction. Right now the 10-year Treasury yield is 4.67 percent, the 2-year is 4.13 percent, so the spread is about 53 basis points. That is a positive spread — the curve is no longer inverted. Luna: Right, because for most of 2023 and 2024 we had that deeply inverted curve, where short-term yields were above long-term yields. That was the classic recession warning. Lucas: Exactly. And the fact that we had that inversion for so long without a recession actually starting made a lot of people skeptical of the signal. But historically, the curve un-inverts — it steepens — right before a recession hits. That's the dangerous phase. Luna: So the steepening itself is the warning, not the inversion. Lucas: Correct. Inversions can last for a year or more. It's when the Fed starts cutting rates and the curve normalizes that the economy often tips over. We're seeing that pattern now. The 10-year yield has actually risen from around 3.8 percent at the end of 2024 to 4.67 percent now, while the 2-year has come down from its peak near 5 percent. Luna: So the long end is going up because... growth expectations? Inflation fears? Both? Lucas: Both. The 10-year is a mix of expected real growth and inflation expectations. The Fed minutes that came out yesterday confirmed officials are worried inflation might stay elevated, and they see a rate hike as possible if that persists. That feeds into higher long-term yields. Meanwhile, the short end is more directly tied to Fed policy, and the market is pricing in rate cuts later this year — that's why the 2-year is lower. Luna: Let me see if I can connect this to what we're seeing in stocks. The S&P 500 is at 7,433, down about 0.9 percent in the last five days. The Nasdaq is off 1.4 percent. Small caps via the Russell 2000 are down 1.6 percent. So the market seems to be pricing in some economic softness. Lucas: Absolutely. And the VIX is at 17.44, up a point in the last week. That's not panic territory — 17 is below the long-term average of about 20 — but it's creeping up. The VIX of VIX, the VVIX, is at 96.45, up 2.3 percent. That suggests options dealers are getting a little more nervous about tail risk. Luna: So the bond market is saying recession risk is rising, the equity market is saying we might get a slowdown, but volatility is still relatively low. That seems like a disconnect. Lucas: It is, and that disconnect is actually the interesting part. Usually the VIX spikes well above 20 when recession fears really take hold. The fact that it's still below 18 suggests a lot of investors are treating this steepening as a garden-variety normalization, not a pre-recession signal. That could mean they're wrong, or it could mean the curve is less predictive this time because of quantitative tightening and the huge amount of Treasury issuance. Luna: Let's talk about that — why would the curve be less predictive now? Lucas: Two big reasons. First, the Fed is still running off its balance sheet, which puts upward pressure on long-term yields independent of growth expectations. Second, the Treasury is issuing a massive amount of debt — over $1 trillion in new issuance this year — and that supply pushes yields higher too. So the steepening might reflect supply and technicals more than a pure economic signal. Luna: So the curve is saying recession, but the technicals are muddying the message. What do you think is the right way to think about it from an investor's perspective? Lucas: I think you look at both. The curve is probably overstating recession risk because of the supply effect. But it's not wrong to be cautious. The Fed minutes were hawkish, growth is moderating — real GDP growth for the first quarter was annualized at 2 percent, down from a much higher pace in 2025. That's still positive, but it's slowing. And if the Fed actually has to hike again, that could be the nail in the coffin for the expansion. Luna: I've also seen some commentary that the 30-year yield at 5.18 percent is a sign the bond market is demanding a term premium again — that compensation for holding long-term bonds is finally back after years of being suppressed. Lucas: That's a great point. For a decade after the financial crisis, the term premium was negative. Now it's positive, and that changes the calculus for bond investors. If you can get 5.18 percent for 30 years, that's a real return above inflation. That's attractive for pension funds and insurance companies. It also means the equity risk premium is smaller, which argues for lower stock valuations. Luna: So the old 60/40 portfolio might actually work again? Bonds providing income and a hedge against equity drawdowns? Lucas: Exactly. But you have to be careful about duration. If yields keep rising, long-term bonds will fall in price. A 30-year bond at 5.18 percent has a lot of interest rate risk. So you might want to stay in the intermediate part of the curve — say 5 to 10 years — where the yield is decent but the price sensitivity is lower. Luna: That sounds like a play on the curve steepening further. If the Fed cuts short rates but long rates stay high, the curve gets even steeper. That's actually a common trade — receive fixed on swaps to profit from steepening. Lucas: Right. And that trade has been working. The spread has widened from around 40 basis points a month ago to 53 now. If the Fed signals a cut in the next few months, I wouldn't be surprised to see it hit 75 or 80. Luna: Before we go deeper, I want to mention something quickly — a lot of listeners have told us they appreciate that we don't have ads on this show. It's something we're committed to. If today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. Lucas: Yeah, it's a small gesture that goes a long way in keeping these conversations going. So — back to the curve. What about the 3-month Treasury? It's at 3.67 percent, down a basis point. The spread between the 10-year and 3-month is a full 100 basis points. That's a massive steepening. Luna: And the 3-month yield is actually below the 2-year now, too. That's another sign that the market expects the Fed to cut aggressively. Lucas: Right. The front end is pricing in a lot of easing. The question is whether that materializes because inflation comes down, or because the economy weakens. The Fed minutes suggest they are more worried about inflation. So if they do cut, it might be because the economy is in trouble, not because inflation is tamed. Luna: That would be bad for equities — cuts in response to a recession are typically met with further declines, not a rally. Lucas: Exactly. The market is now pricing in about two quarter-point cuts by the end of the year. If those happen because the economy is slowing, stocks could drop another 10-15 percent from here. The S&P 500 is already down from its highs earlier this year. We're around 7,433 now, down about 5 percent from the peak in March. Luna: So your base case for the rest of 2026 — slower growth, sticky inflation, curve steepening, moderate equity downside? Lucas: Something like that. I don't think we get a full-blown recession this year — the consumer is still spending, corporate earnings have been resilient — but the risk is rising. The bond market is basically saying, 'prepare for a slowdown.' And the equity market hasn't fully priced that in yet. Luna: That seems like a good note to leave it on. Any final thoughts on how an individual investor should position? Lucas: I'd say, don't ignore the bond market. If you've been all stocks, consider shifting a portion to intermediate Treasuries or investment-grade corporates. You're getting a real yield for the first time in years, and it provides a buffer if equities fall. And if the curve is right about a recession, you'll be glad to have that income. Luna: Alright, Lucas. Good conversation. Lucas: Thanks, Luna. See everyone next time.