Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Bond Market Is Sending a Contradictory Signal on Growth
Transcript
- Lucas: So the yield curve has been doing something this spring that I think a lot of people are misreading. The two-year yield is down about 40 basis points since April, but the ten-year yield is actually up about 20 basis points over the same stretch. Luna: Which means the curve is steepening — but not because the economy is heating up. Lucas: Exactly. Normally when you see a steepening curve, it's because markets expect stronger growth and maybe higher inflation down the road. The long end rises faster than the short end. But here, the short end is falling because traders are pricing in rate cuts, while the long end is rising for a completely different reason. Luna: Which is what — supply? Term premium? Lucas: Both. The Treasury's borrowing needs aren't going away. We're looking at a fiscal deficit that's still running above 6 percent of GDP. And on top of that, the Fed is still letting its balance sheet roll off — quantitative tightening, even if at a slower pace. So there's a wall of supply hitting a market where the biggest traditional buyer, the Fed, is actually a net seller. Luna: And that pushes term premium higher. So the ten-year is yielding 4.49 percent right now, which is up from around 4.2 in March. But the two-year is at 3.62, down from over 4 percent earlier this year. Lucas: Right. And that divergence tells you two things simultaneously. One: the market believes the Fed will cut rates, probably later this year. Two: the market is demanding more compensation to hold long-term government debt because of uncertainty around fiscal policy, inflation persistence, and the sheer volume of issuance. Luna: So it's not a classic 'steepening on good news' signal. It's more like a 'stuck between cuts and supply' signal. Lucas: That's exactly the phrase I've been using. And historically, this type of steepening — where the short end falls faster than the long end rises — has actually been a warning sign. If you look at 2001, 2007, even 2019, you saw similar patterns before economic slowdowns. The market smells trouble ahead, so it prices in easier monetary policy, but the bond vigilantes are demanding a premium for the risk of holding long-duration paper in an uncertain environment. Luna: Let's talk about the international dimension, because the ECB just hiked rates for the first time since 2023. That was a big move, driven by the energy shock from the Iran situation. How does that feed into the US yield dynamics? Lucas: It matters because higher rates in Europe make European bonds more attractive relative to US Treasuries, all else equal. But what we've actually seen is a bid for US Treasuries from foreign buyers looking for safety — so that's been a dampener on long-term yields, not an accelerant. The bigger channel is through inflation. The ECB hike is a recognition that energy costs are feeding through to core prices globally. Luna: And we saw that wholesale prices jumped 1.1 percent in May, which was way above expectations, driven by energy. That number came out on June 11. Lucas: Right. So the PPI data reinforces the narrative that inflation isn't going away quietly. The ten-year breakeven inflation rate is at 2.31 percent as of last Friday. That's up from 2.29 the week before, but it's still below the 2.5 or 2.6 we saw earlier in the year. So the market is saying inflation expectations are somewhat anchored, but the realized inflation data is still hot. Luna: Which puts the Fed in a tough spot. You mentioned rate cuts are being priced in. But if inflation is running at 4.2 percent on CPI and the Fed funds rate is 3.63, they're still negative in real terms. How do you cut from there? Lucas: You can't, really. Unless you believe inflation is about to fall sharply — and the data doesn't support that yet. The core PCE, which is the Fed's preferred measure, is at 2.8 percent year-over-year based on the April reading. That's down from 2.9, but it's still well above the 2 percent target. Luna: So the bond market's signal is almost contradictory. The short end says 'help is coming.' The long end says 'I'm not so sure.' Lucas: And the middle of the curve — the five-year, for example — is caught in between. The five-year yield is at 4.21, down about 10 basis points over the last month. That's a market that's pricing in cuts but doesn't really believe they'll happen soon. The implied path from fed funds futures shows about 50 basis points of cuts by year-end. But with inflation where it is, I think the Fed would need to see several months of benign data before they pull the trigger. Luna: And the jobs market isn't breaking. The unemployment rate is still 4.3 percent, but that's up from 3.7 a year ago. Job openings jumped to 7.6 million in April from 6.9 million in March. So the labor market is still pretty tight. Lucas: Yeah, the JOLTS data was a surprise. That was the highest reading in about four months. It suggests that businesses are still trying to hire, even if the pace of hiring has slowed. And initial jobless claims are creeping up — 229,000 last week, up from 225,000. But that's still low historically. Luna: So the economy is in this weird zone where growth is slowing but not collapsing, inflation is sticky, and the bond market is pricing two different scenarios at once. Lucas: That's the macro puzzle right now. And the real risk is that the longer the curve stays steep in this 'bad' way, the more it acts as a drag on the economy itself. Higher long-term rates feed into mortgage rates, corporate borrowing costs, and the government's own interest expense. Luna: Speaking of which, the 30-year yield is at 4.97 percent. Almost 5 percent. That's a big number for a 30-year bond. Lucas: It is. And it's remarkable because the 30-year is usually the most sensitive to inflation expectations. The fact that it's approaching 5 percent while the 10-year breakeven is only 2.31 tells you that the term premium is doing a lot of the heavy lifting. Investors aren't just worried about inflation — they're worried about the uncertainty around fiscal policy, geopolitical risk, and the sheer amount of debt that needs to be absorbed. Luna: If walking through the economy with us has made something click — maybe the way the bond market speaks, or why the Fed is stuck — and you want to support the show staying independent and ad-free, we have a page for that. It's buy me a coffee dot com slash fexingo. No pressure, just if the show adds value for you. Lucas: That's exactly right. It has helped us keep this going without any sponsors or ads, and it keeps the conversation honest. So if you feel like it, that's the spot. Luna: Alright, back to the curve. So if the Fed doesn't cut this year, what happens to the steepening trade? Lucas: It probably continues, but the composition could shift. If the economy softens more than expected, the two-year could fall further as rate-cut bets intensify. That would steepen the curve even more. But if inflation surprises to the upside, the long end could rise faster, and then you get a bear steepener — which is worse for risk assets because it means higher discount rates. Luna: And the equity market seems to be ignoring this, at least for now. The S&P 500 is at 7,431, up 0.3 percent over the last five days. The Russell 2000 is up 3.1 percent over the same period. Small caps are rallying. Lucas: That's interesting because small caps are usually more sensitive to interest rates. Their debt tends to be floating-rate, so higher rates hit them harder. The rally suggests that investors are betting on a soft landing and eventual rate cuts. But if the bond market is right and the economy is heading for a harder landing, that rally could reverse quickly. Luna: So the bond market is essentially arguing with the stock market. And the bond market has a better track record of calling recessions. Lucas: It does. The yield curve has predicted every recession in the last 50 years, with only one false positive. But the curve we're talking about now isn't the classic inversion that everyone watched last year. That inverted curve has already normalized — it's no longer inverted. The two-year is at 3.62, the ten-year at 4.49, so the spread is positive 87 basis points. Luna: Right, but the fact that it disinverted without a recession is actually rare. Usually the curve uninverts because the Fed cuts rates in response to a downturn. This time it's happening because the two-year fell on expectations of cuts, not because cuts actually happened. Lucas: That's the nuance that a lot of headlines miss. The curve is no longer inverted, but the signal is still cautionary. It's saying the economy is decelerating, inflation is sticky, and the Fed is in a box. Luna: So what are you watching for next? What data point would change your view? Lucas: Two things. One: the June CPI report, due out next month. If it comes in below 4 percent annual, that would be a big deal. Two: the Fed's dot plot at the June FOMC meeting, which is actually later this week. If the median projection moves from one cut to two, or from two to zero, that will tell us a lot about where the committee thinks the economy is heading. Luna: And if they signal zero cuts, the market will have to reprice. Lucas: Dramatically. The two-year would likely spike back up, and the curve would flatten or even re-invert. That would be a shock to risk assets. But if they signal cuts, the bond market will take it as confirmation and the steepening could accelerate. Either way, this week is a big one for the macro narrative. Luna: Alright, we'll be watching. Thanks, Lucas. Lucas: Thanks, Luna. Talk to everyone tomorrow.