Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The 2.26 Percent Breakeven That Has the Fed Second-Guessing
Transcript
- Luna: So the 10-year breakeven inflation rate just dropped to 2.26 percent. That is the lowest it has been in months. And it is weird because CPI is running at 4.2. Lucas: Yeah, that gap is really the whole story right now. The breakeven rate is basically what the bond market expects inflation to average over the next decade. 2.26 percent is actually below the Fed's 2 percent target if you think about it — because the Fed targets 2 percent on PCE, not CPI. CPI tends to run a bit hotter. So the market is essentially saying, 'We believe inflation is coming down, maybe even below the Fed's comfort zone in the long run.' Luna: But the latest CPI print was 334.0 on the index, up from 332.4 the month before. That is not exactly disinflationary momentum. Lucas: Right. And that tension is what makes this interesting. On one hand, you have actual reported inflation still sticky — 4.2 percent year-over-year on CPI, core at similar levels. On the other hand, the bond market is effectively saying, 'We don't think this lasts.' The breakeven is priced off the difference between nominal Treasury yields and Treasury Inflation-Protected Securities. The 10-year nominal yield is around 4.44 percent, and the 10-year TIPS yield is about 2.18 percent. That spread is the breakeven. Luna: So the market is betting that the Fed's rate hikes — or the lack of cuts — will eventually crush demand enough to bring inflation down. Lucas: Exactly. And Kevin Warsh just had his first meeting as Fed chair last week. The headline takeaways were mostly about how he is trying to thread the needle between fighting inflation and not tipping the economy into recession. But the breakeven drop suggests the market thinks he might actually succeed — or at least that the risks are tilted toward lower inflation, not higher. Luna: But if that is the case, why are job openings surging? JOLTS just came in at 7.6 million, up from 6.9 million. That is a big jump. A tight labour market usually keeps wage pressure up. Lucas: That is the other data point that makes this confusing. Average hourly earnings are up to $37.50, which is about a 3.6 percent year-over-year gain. That is not runaway wage growth, but it is consistent with inflation staying above target. So you have a labour market that is still adding jobs — nonfarm payrolls at 159 million — and wages ticking up, yet the bond market is pricing in lower long-run inflation. Luna: Maybe the bond market is looking past the near-term noise and focusing on the fact that real GDP growth is only 1.6 percent annualized. That is not exactly booming. Lucas: That is a good point. Real GDP growth in the first quarter was just 1.6 percent, up from a very weak 0.5 percent in the prior quarter. So the economy is growing, but slowly. And if you look at the Fed funds rate at 3.63 percent, that is well above any estimate of the neutral rate. So monetary policy is restrictive. The market might be betting that this restrictive stance eventually cools the economy enough to bring inflation down, even if the labour market is still hot right now. Luna: There is also the global context. The Bank of England just held rates at 3.75 percent, and UK inflation is at 2.8 percent. Europe is not exactly overheating. And the Iran situation — three tankers just exited the blockade — that could have implications for oil prices. Lucas: Yeah, the geopolitical piece is definitely a wildcard. If oil prices fall further, that would directly lower headline inflation and make the Fed's job easier. But the breakeven drop predates that headline by a bit. So I think the market is saying something structural about the economy, not just reacting to geopolitics. Luna: What does that mean for the Fed's next move? They are stuck at 3.63 percent with inflation at 4.2. They cannot cut without risking a reacceleration, but if they hold too long, they might kill the expansion. Lucas: Right. And the bond market is basically telling them, 'If you hold steady, inflation will come down on its own.' But the Fed has been burned before by transitory inflation narratives. Warsh is probably cautious. I think the most likely scenario is they hold through the summer, maybe into the fall, and see if the breakeven continues to fall and if the labour market softens. If job openings start dropping back toward 6 million, that gives them cover to cut. Luna: But what if the breakeven keeps falling and inflation stays high? That would be a real conundrum. The market would be pricing in deflation while actual prices keep rising. Lucas: That is the stagflation nightmare scenario. But I think it is unlikely. The breakeven is a market-based measure, and it can be distorted by liquidity or by demand for TIPS. Right now, there is actually a lot of demand for inflation protection from institutional investors, which pushes TIPS prices up and yields down, widening the spread. But the nominal yield has also fallen, so the net breakeven is lower. It is not a perfect signal. Luna: Still, it is one of the best we have. And it is saying something different from the CPI data. Lucas: Exactly. And that kind of disagreement is exactly what makes macro interesting right now. The Fed has to decide which signal to trust. My bet is they lean on the hard data — CPI, payrolls — and keep rates where they are. But the bond market is already pricing in a cut by year-end. The 2-year yield is at 3.66 percent, basically flat with the Fed funds rate, which suggests the market expects rates to stay here or go slightly lower. Luna: So the market is betting on a pivot, but the Fed is not ready to signal one. Lucas: That is the standoff. And it is going to be resolved by the next few months of data. If inflation ticks down even a little, the market will be validated. If it stays sticky, the Fed will have to talk tough, and yields might rise again. Luna: One thing that gives me pause: the 10-year breakeven has been falling for a while, but the 5-year breakeven is probably even lower. That suggests the market thinks disinflation happens relatively quickly, then inflation settles around 2 percent. Lucas: Yeah, the 5-year breakeven is around 2.1 percent if I remember right. So the market is saying inflation gets back to target in the next few years. That is a pretty benign outlook. But it requires a lot of things to go right — no new supply shocks, no wage-price spiral, no geopolitical flare-up. Luna: And we have seen how quickly those assumptions can break. Lucas: Absolutely. So the cautious take is that the breakeven is a useful signal, but not a guarantee. The Fed will want to see more data before they change course. And the labour market is the key. If job openings start to fall consistently, that is when they might act. Luna: It is fascinating to watch this play out in real time. And it is exactly the kind of thing that makes following macro worth it — you get to see the market and the central bank kind of wrestling with each other. Lucas: Speaking of following macro — and I mean this genuinely — a handful of listeners actually make this show possible by chipping in monthly over at buy me a coffee dot com slash fexingo. That is literally what keeps us ad-free and able to do deep dives like this every day. Luna: Yeah, it is a small group, but it means we do not have to chase sponsors or soften the analysis. If you get value from these conversations, that is where you can help keep them going. Lucas: No pressure at all. But if walking through the economy with us has made something click, that link is there. And back to the breakeven — I think the big question is whether Warsh acknowledges this signal in his next speech. The market will be listening for any hint that the Fed sees the same disinflationary forces. Luna: The next FOMC meeting is in late July. That gives them six weeks of data. If the breakeven stays low and job openings dip, we could see a real shift in tone. Lucas: Exactly. And that is the kind of inflection point that makes this job interesting. We will be watching it closely.