Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Tracks the Real Rate Through Ten-Year Breakevens
Transcript
- Lucas: So the ten-year breakeven ticked up to 2.28 percent last week. That's not a huge move, but it comes at a moment when the Fed is really split on what to do next. And I think the more interesting story is what that number implies for the real rate. Luna: For someone who doesn't track breakevens daily, what does that 2.28 actually tell us? Because it sounds like just another inflation number. Lucas: Right, so a breakeven is the market's expectation of average inflation over the next ten years, derived from the difference between nominal and inflation-protected Treasury yields. And when it goes up, it's often read as inflation expectations rising. But here's the twist: real yields have actually been climbing too, which means the nominal yield on the ten-year is now 4.74 percent. So investors are demanding more compensation for both inflation and the real return on their money. Luna: And that's what the Fed cares about, right? Because the real rate is what actually affects borrowing and spending decisions, not the nominal rate. Lucas: Exactly. And that's the lens I want to look through today. Because with core PCE still sticky at 130.3, up from 130.09, and GDP growth slowing to 1.5 percent in Q2, the Fed has to figure out whether the real rate is already tight enough to cool the economy, or if they need to do more. The breakeven is a window into that debate. Luna: Before we go deeper, I have to say this is exactly the kind of episode that makes me want to support the show. If breaking down these numbers helps you see the economy clearer, you can keep us ad-free by buying us a coffee at buy me a coffee dot com slash fexingo. It's a small gesture that goes a long way. Lucas: Yeah, we appreciate that. Now back to the real rate. So the real rate is basically the nominal yield minus expected inflation. With the ten-year at 4.74 and breakevens at 2.28, that implies a real yield of around 2.46 percent. That's historically high. Luna: Historically high? Where does that sit compared to the past decade? Lucas: Well, for most of the post-2008 period, real yields were below one percent, sometimes even negative. So 2.46 is a big deal. It means the market is pricing in a pretty restrictive stance from the Fed. And that has direct implications for mortgages, corporate borrowing, and even stock valuations. Luna: So if the real rate is already that high, why is the Fed still debating whether to hike? You'd think that would do the job. Lucas: That's the crux. Some Fed officials argue that the real rate is indeed restrictive and that they should hold steady, maybe even start cutting later this year. Others, like Chair Warsh, seem concerned that inflation isn't coming down fast enough, so they might need to keep rates higher for longer. The divide is real, and this data point is at the center of it. Luna: And the fact that core PCE just ticked up, even if barely, gives the hawks ammunition, doesn't it? Lucas: It does. And that's why the breakeven move matters. If inflation expectations start to drift up, the Fed's credibility is on the line. But if they overreact and push real rates even higher, they risk choking off growth. The Fed has to walk a very fine line. Luna: So how do they actually use the real rate in their projections? Is it something they explicitly target? Lucas: Not exactly, but it's embedded in their thinking about the neutral rate. We did an episode on that recently, but the short version is: the neutral rate is the rate that neither stimulates nor restricts the economy. And it's a real rate, not nominal. So when they estimate the neutral rate, they're really asking 'what is the real rate that keeps the economy balanced?' Luna: And if the market's real rate is already above that neutral estimate, then policy is restrictive by default. Lucas: Exactly. And that's why you see some economists saying the Fed might already be too tight. With GDP growth at 1.5 percent, that's below the potential growth rate, so there's slack in the economy. But inflation is still above target. So the real rate is doing its job, but maybe not fast enough for some. Luna: Where does the ten-year breakeven come from again? Is it a direct market read or an estimate? Lucas: It's derived from inflation-protected securities, like TIPS. The difference between the nominal ten-year and the ten-year TIPS yield gives you the market's implied inflation expectation. It's not perfect, because it includes a premium for liquidity and inflation risk, but it's the most direct market-based measure we have. Luna: So when that number moves, it's essentially the bond market voting on inflation. Lucas: Exactly. And right now, the vote is for slightly higher inflation, but not runaway. 2.28 is still within the Fed's comfort zone if you think about their symmetric target. But the movement in real yields is what's doing the heavy lifting in terms of tightening financial conditions. Luna: What does that mean for the average person? Higher mortgage rates, I assume. Lucas: Definitely. The thirty-year fixed-rate mortgage tracks the ten-year yield pretty closely. With the ten-year at 4.74, you're looking at mortgage rates around 6.5 to 7 percent. And that's a direct result of the Fed's policy stance, because they control the short end, but the long end is driven by expectations of where rates are going and inflation. Luna: So even if the Fed holds rates steady, if the market thinks inflation is going to be higher, long-term yields rise, and that tightens policy automatically. Lucas: Right. That's what the market calls an 'accidental tightening.' The Fed doesn't have to lift a finger, but financial conditions get tighter because bond yields rise. And that's exactly what we're seeing now. The five-day change in the ten-year yield is up 2.2 percent, and the thirty-year is up 2.9 percent. So the long end is moving faster than the short end. Luna: And the two-year yield has been falling lately, right? We did an episode on that. So we're seeing a flattening curve, maybe even inversion again? Lucas: The two-year is at 3.68, down three percent over the last five days, while the ten-year is at 4.74. So the spread is actually positive, but it's narrowing. That's a sign that the market expects the Fed to cut rates in the near term, but longer-term inflation expectations are keeping the ten-year elevated. It's a bit of a mixed signal. Luna: So what's the takeaway for investors? How should they interpret this real rate signal? Lucas: The key is to watch the real rate as a leading indicator. If it keeps climbing, that's going to put pressure on equities, especially growth stocks that are valued on future earnings. On the other hand, if the Fed signals a pause and the real rate stabilizes, that could be a relief rally. But right now, the real rate is still above what many consider neutral, so caution is warranted. Luna: And with the Fed divided, that uncertainty itself is a risk factor. Lucas: Absolutely. The Fed's internal divide means policy is harder to predict, and that usually leads to higher volatility. The CBOE volatility index, or VIX, tends to spike when the Fed is in between a rock and a hard place. And we saw that in July when the Q2 GDP number came in weak but core inflation stayed sticky. Luna: So, Lucas, if you had to bet, what do you think Warsh's Fed does at the next meeting? Lucas: I think they hold rates steady, but the statement will emphasize that they're watching the real rate closely. They'll probably say something like 'financial conditions have tightened significantly' and leave the door open for a cut later if inflation continues to moderate. But given the core PCE tick-up, I don't think they're ready to commit to a cut yet. Luna: So it's a wait and see approach, with the real rate as the key barometer. Lucas: Exactly. And the breakeven is the easiest way to watch it. If the ten-year breakeven starts drifting above 2.5, that's a red flag. If it falls back to 2.1, that gives the doves more room. Right now, we're in that 2.2 to 2.3 range, which is basically neutral. So the market is telling us the Fed has a little bit of time, but not much. Luna: That's a great distillation. So for our listeners, the takeaway is to track the ten-year breakeven as a simple way to gauge inflation expectations and the real rate. Lucas: And if you look at that number alongside the nominal yield, you can actually calculate the real rate yourself. It takes five seconds. And it gives you a real edge in understanding what the Fed is thinking. Luna: I love that. It's a concrete tool you can use without a finance degree. Lucas: Right. And that's the kind of clarity we try to bring every episode. So next time you see a headline about breakevens, you'll know it's really about the real rate, and you'll know why it matters.