Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Reads Falling Breakeven Rates
Transcript
- Lucas: So the S&P 500 just closed at 7,511. The Dow is at 52,000. The Nasdaq is up nearly five percent in five days. By almost any measure, risk assets are having a moment. Luna: And yet, the bond market is sending a different signal. The ten-year breakeven inflation rate — that's the difference between nominal Treasury yields and TIPS yields — it's fallen to 2.29 percent. Lucas: Right. Down from 2.32 just a few days ago. And that's the number I think the Fed is watching more closely than the latest CPI print right now. Because the CPI came in hot — May headline was up again — but the market's pricing in lower inflation over the next decade? Luna: So the equity rally says 'risk on, economy fine,' but the bond market says 'inflation is cooling and maybe growth is too.' Lucas: Exactly. That's the disconnect. And for the Fed, the breakeven rate is a cleaner window into expectations than any survey. It's real money. People are betting their own capital. Luna: Let's step back for a second. How does this work practically? If I'm an investor, I can buy a ten-year Treasury at around 4.43 percent nominal yield, or I can buy a ten-year TIPS that pays a lower nominal coupon but adjusts for inflation. The difference is the breakeven. Lucas: That's exactly right. So if the nominal yield is 4.43 and the TIPS yield is 2.14, the breakeven is 2.29. The market is saying: we expect inflation to average 2.29 percent over the next ten years. That is almost exactly the Fed's target. Luna: But it's coming down. From 2.32 to 2.29 in a week. That's three basis points. Not huge, but the direction matters. Lucas: And it's happening while headline CPI is still running above 3 percent. So the bond market is essentially saying the recent CPI spikes are transitory — or at least, they won't persist. The Fed might see that as validation of their cautious stance. Luna: On the other hand, a falling breakeven could also signal that the market sees a recession on the horizon. Because if growth tanks, inflation tends to fall. Lucas: And that is the tension. The equity market is rallying on the assumption that the Fed is done hiking, maybe even cuts later this year. But the bond market's inflation expectations are softening, which could be consistent with a slowdown. The Fed might see that and think: we don't need to cut yet, because inflation expectations are well anchored. Luna: So what's the Fed's likely read right now? We're at 2.29 on the ten-year breakeven. The fed funds rate is at 3.63. The economy is growing, but there are headwinds from the Iran situation, the UK shrinkage, the ECB just hiked. Lucas: I think the Fed looks at 2.29 and breathes a small sigh of relief. It's almost perfectly aligned with their symmetric 2 percent target. They don't want it to fall much further, because that would signal deflation risk. And they don't want it to spike, because that would mean they've lost credibility. Luna: But if the equity rally continues and breakevens keep falling, that's a recipe for a policy mistake. The Fed could stay tight too long because they see anchored expectations, while the real economy is actually weakening. Lucas: That's the nightmare scenario. And it's why Chair Powell's next press conference is going to be so carefully parsed. The market wants to hear that the Fed is data dependent, but also that they see the same signals we do. Luna: One more interesting layer: the yield curve. The two-year yield is at 3.63, the ten-year at 4.43. That's a steep curve. An uninversion. Historically, that often happens before a recession. Lucas: Yeah, the curve has been uninverted for a few weeks now. And falling breakevens alongside a steepening curve is a classic 'bad news is bad news' signal. It means the bond market is pricing in lower inflation but also weaker growth. Not the goldilocks scenario equities are betting on. Luna: So one of these markets is wrong. Either equities are too optimistic, or bonds are too pessimistic. Lucas: And the Fed's job is to figure out which one. They can't afford to ignore either signal. If they lean too hard on the equity rally, they risk letting inflation reaccelerate. If they lean on bonds, they risk tightening into a downturn. Luna: What about the geopolitical piece? Three Iranian tankers just exited the U.S. blockade. That's a big deal for oil prices. If energy spikes again, that could push headline CPI up and maybe lift breakevens. Lucas: Absolutely. The May wholesale price report showed a 1.1 percent jump, driven by energy. If that continues, the bond market's current inflation expectations could be too low. The Fed has to weigh that against the demand slowdown from Europe and the UK. Luna: So the breakeven rate is almost like a Rorschach test. You can see whatever you want in it. Lucas: That's why they look at so many data points. But I think this week, the ten-year breakeven is the single most important number for understanding where the Fed's head is at. It's telling them the market trusts their inflation fighting. And that trust is fragile. Luna: Which brings us to a quiet truth about this show. Lucas and I go deep on these numbers every day, and that's only possible because of a small group of listeners who chip in to keep it ad-free. If you've ever wondered how we fund this operation without running a single ad — it's literally listeners like you, through buy me a coffee dot com slash fexingo. No pressure, just a fact. Lucas: Yeah, and we mean that. The show stays independent because a handful of people find value in it and want to keep it that way. If that's you, you know where to find us. And if not, no worries — we're glad you're listening either way. Luna: Okay, back to the breakeven. So if we're the Fed, what's the one thing we watch for in the next CPI release? Lucas: Core services ex-housing. That's the stickiest component. If that starts to moderate, the breakeven might fall further. If it holds steady, the Fed stays on hold. The breakeven is a summary statistic, but the details underneath matter. Luna: And if the breakeven drops below 2 percent? That would be a whole new conversation. Lucas: That would be the Fed's worst fear realized. Deflation scare. But we're not there yet. 2.29 is still right in the sweet spot. For now, the bond market is giving the Fed the benefit of the doubt. And that's a gift they won't squander.