Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Two-Year Yield Is Rising While the Fed Holds
Transcript
- Lucas: The two-year Treasury yield is sitting at 3.76 percent this morning, up nearly one and a half percent over the last five days. Meanwhile, the effective federal funds rate is flat at 3.63. So the short end of the curve is sending a signal that the central bank is not yet sending itself. Luna: Right — the two-year is basically the market's best guess at where the Fed will set rates in the near term. So that gap is worth paying attention to. Lucas: Exactly. And the question is whether this is just noise — a temporary repricing after the holiday week — or something more structural. I think it's the latter. The catalyst seems to be the new tariff round that the administration announced last week, plus that surprise gain in import prices from China, which hit their highest level since 2008. Luna: That combination — tariffs plus higher import costs — is basically a supply shock. And supply shocks are exactly the kind of thing that can push inflation up without adding demand. That's the worst kind for the Fed because raising rates doesn't fix it. Lucas: Right. But the market is pricing in a higher probability of a rate hike anyway — probably because they think the Fed will feel compelled to act if headline inflation starts creeping back up. And to be fair, the PCE price index has been ticking up. The May reading came in at 131.5, up from 130.94. Core PCE is also up. Luna: So you've got hard data moving in one direction and market expectations moving in the same direction, but the Fed's own dot plot and public statements are still very much in 'wait and see' mode. How do they reconcile that? Lucas: It's a tension. The Fed has been leaning on the fact that breakeven inflation rates — market-based expectations — have been falling. The ten-year breakeven is now at 2.20 percent, down from 2.21 last week. That gives them cover to hold. But if the two-year yield is rising partly because of tariff fears, that's a different kind of signal. It's not about expected inflation; it's about expected policy response. Luna: So the market thinks the Fed will hike, but the Fed thinks the market is wrong? That's a recipe for volatility. Lucas: Exactly. And we've seen this movie before. In 2023, the two-year yield spiked several times on tariff news, and each time the Fed looked through it. But this time the macro backdrop is different. Core CPI has fallen — it's at 336.1, down from 336.12 — but services inflation remains sticky. And shelter, which is the biggest component, is still the Fed's biggest headache, as we discussed last episode. Luna: So if the Fed holds, and the two-year yield stays elevated, what does that do to financial conditions? It could tighten them without the Fed actually moving. Lucas: That's the big risk. If the market does the Fed's work for it, then the Fed can afford to stay patient. But if the market overdoes it — if the two-year climbs too high — it could choke off the soft landing that the Fed is trying to engineer. That's why the next FOMC meeting in September is going to be fascinating. They'll have updated projections, and we'll see whether the dots move. Luna: You mentioned import prices from China. What's the latest there? The headline said they hit the highest since 2008. Lucas: Yeah, the import price index for goods from China posted a surprise gain in June. That's directly tied to the tariff structure. The administration's new global tariff — justified on forced labor grounds — is broader than previous rounds. So it's not just about China; it's about Vietnam, Mexico, other supply chain alternatives. But China is still the biggest source of consumer goods imports, so the passthrough to retail prices could be significant. Luna: And the Fed's models typically treat tariffs as a one-time price level shift, not a persistent inflation driver. But if tariffs keep escalating, that assumption breaks down. Lucas: Right. And there's also the Singapore angle. Last week the Monetary Authority of Singapore tightened policy in a surprise move, citing rising oil prices and inflation risks. That's a signal that global central banks are still worried about imported inflation. The Fed can't ignore that entirely. Luna: So what's your take: does the two-year yield keep rising, or does it fade as markets digest the tariff details? Lucas: I think it depends on the data we get between now and September. If the July CPI and PCE numbers show a renewed uptick, the two-year will probably push higher. But if the breakeven rates continue to drift lower — meaning markets don't believe the inflation will stick — then the two-year might actually fall back. The breakeven is the key to watch because it captures both inflation expectations and real rate expectations. Luna: That feels like a good transition to something we've been meaning to mention. You know, we do these shows every day, no ads, no sponsors. And that's a choice. If walking through the economy with us has made something click, you can support that choice at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a simple way to keep this ad-free. No perks, no tiers, just knowing that the show is funded by listeners who find it useful. And we appreciate that. Luna: Alright, back to the yield curve. So the breakeven rate is one signal, but the two-year is another. Which one does the Fed trust more right now? Lucas: Historically, the Fed has put more weight on survey-based measures of inflation expectations — like the University of Michigan survey or the Philadelphia Fed's SPF — but they also watch breakevens closely. The two-year yield, though, is less about inflation and more about near-term policy expectations. So I'd say the Fed is probably paying more attention to the breakeven because it directly relates to their mandate. But if the two-year continues to climb, that will force them to address it in the minutes. Luna: One thing that stands out to me: the two-year is up while the ten-year is actually down a bit. The ten-year yield is at 4.60, down 0.3% in five days. So the curve is flattening in that segment. Lucas: Good catch. The ten-year is being pulled down by safe-haven flows and maybe a bit of a growth scare. Tariffs are bad for growth, so long-term yields can fall even as short-term yields rise. That's a classic 'tariff flattening' pattern. It's actually the opposite of what we saw earlier this year when the curve was steepening on fiscal spending expectations. Luna: So we've got a two-year yield that's pricing in tighter policy, a ten-year that's pricing in weaker growth, and a breakeven that's saying inflation is under control. That's a messy combination for the Fed. Lucas: It is. And it's why the Fed is likely to stay on hold for now. They need more data — especially those July PCE numbers — to see which signal is the outlier. But I think the real takeaway for listeners is that the bond market is not as calm as the headlines suggest. The two-year yield moving this much without a Fed move is itself a story. Luna: And it's a story that could have real consequences for mortgage rates, car loans, anything tied to short-term rates. Lucas: Absolutely. So we'll keep watching the two-year. If it breaks above 3.80, that's a line in the sand. And if it does, we'll see how the Fed responds in their next communication.