Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Ignores the Yield Curve Inversion Now
Transcript
- Lucas: So the yield curve is inverted — deeply inverted — and the Fed is basically shrugging. The two-year Treasury is yielding about four-point-four-five percent, the ten-year is at four-point-one-eight. That's a gap of roughly 83 basis points. By any historical standard, that is a screaming recession warning. But when you read the FOMC minutes, there's almost no hand-wringing about it. Luna: Right, because the classic playbook says an inverted curve means the market expects the Fed to cut rates soon — usually because something bad is about to happen. But the Fed isn't cutting, and they don't seem to think anything bad is imminent. Lucas: Exactly. And that tension is the whole story of this episode. The curve has been inverted — off and on — since mid-2022. That's over three years. The longest stretch since the late 1970s. And yet the economy is still adding jobs — we got that April JOLTS number yesterday, job openings surged to 7.6 million, the highest in nearly two years. GDP is growing. The consumer is spending. So either the recession is the most patient thing in the world, or the signal is broken. Luna: I remember in 2023 everyone was screaming inversion equals recession within twelve months. Twelve months came and went. Then eighteen months. Now we're past three years. So what changed? Why doesn't the Fed trust this indicator anymore? Lucas: It's not that they don't trust it — it's that they've learned to decompose it. The yield curve has two components: expectations about future short-term rates, and the term premium — the extra compensation investors demand for holding longer-term bonds. What's happening now is that the term premium has turned sharply negative. Investors are willing to accept a lower yield on the ten-year because they want safety and liquidity, not because they think the Fed will slash rates. Luna: Meaning the inversion is a 'flight to safety' inversion, not a 'policy easing' inversion. Lucas: Precisely. And that's a crucial distinction. In a classic inversion, the market sells off long-term bonds because it expects weak growth and rate cuts. But today, the buying pressure on long-term Treasuries is coming from global investors — pension funds, sovereign wealth funds, central banks — who are parking cash in the safest asset they can find, especially with the Iran situation rattling energy markets. They're not trying to front-run a rate cut; they're just hedging risk. Luna: And that's why the Fed can look at the inversion and say, 'This is mainly a technical supply-demand story, not a recession signal.' But isn't there a risk they're being too complacent? The last time the curve stayed inverted this long, we had the Savings and Loan crisis, then the 2001 dot-com bust, then 2008. Lucas: That's the counterargument. But let's look at the composition of the inversion today. The short end — the two-year — is elevated because the Fed funds rate is at 3.62 percent. And the market believes the Fed will keep it there for a while. The long end — the ten-year — is being pulled down by that global bid for safety. So the inversion is a reflection of policy tightness plus global risk aversion, not a collapse in growth expectations. Luna: But if global risk aversion suddenly unwinds — say the Iran situation de-escalates — then the ten-year could spike back up, and the curve would steepen. That might actually be more dangerous for the Fed, because it would tighten financial conditions through higher long-term rates. Lucas: That's a great point. The Fed has to watch two-way risk. If the curve stays inverted because of safety bids, that's benign. But if it inverts because the market starts pricing in a recession — that's a problem. And we saw a hint of that in early May when the ten-year briefly dipped below 4.0 percent. That was a growth-scare move. It didn't stick, but it shows the market is still jittery. Luna: Let me push on that. The Fed's own dot plot from the March meeting showed two cuts projected for this year. That's consistent with a soft landing. But the market is pricing in less than one cut. So the market is actually more hawkish than the Fed. That seems like the opposite of what you'd expect during an inverted curve. Lucas: Right, and that goes back to the term premium point. The market isn't pricing cuts because it doesn't expect a recession. It's pricing no cuts because inflation is still sticky — core PCE came in at 129.6 in April, up from 129.32. That's above the Fed's target. So the short end is anchored by sticky inflation and a Fed that's on hold. The long end is anchored by safety demand. That's a recipe for a persistent inversion. Luna: So how do you know when the inversion is actually predicting a recession versus just being a technical artifact? Is there a threshold? Lucas: There's no single number, but one thing to watch is the spread between the two-year and the ten-year's 'near-term forward rate.' That's a cleaner measure because it strips out some of the term premium noise. That spread has been narrowing but hasn't gone negative. Also, watch the three-month to ten-year spread — that one is actually positive today, because the three-month bill yields about 3.62, same as the fed funds. That part of the curve isn't inverted. Historically, the three-month to ten-year spread has been a better recession predictor than the two-ten spread. Luna: So the classic inversion everyone talks about — the two-ten — might be a red herring right now. Lucas: That's the Fed's argument, and I think it's largely correct. But there's a risk: if the economy does slow and the curve remains inverted because the Fed doesn't cut fast enough, then the inversion becomes self-fulfilling. High short-term rates eventually squeeze the banking sector, small businesses, and variable-rate borrowers. That's the delayed effect that keeps me up at night. Luna: And that's where the job market data matters. 7.6 million openings is tight. But if that number starts to fall, and the curve stays inverted, then you have to worry. Lucas: Exactly. So the Fed's current posture — watching, not reacting — makes sense for now. But they need to be ready to pivot if the composition of the inversion changes from safety-bid to growth-fear. And I think that's the key takeaway: the yield curve isn't broken as an indicator; it's just giving a different signal than it gave in the past. You have to read the context. Luna: We've been talking about how the Fed reads the yield curve. If walking through the economy with us has helped make something click, that's exactly the kind of thing that keeps this show going ad-free. We're listener-supported, and it's listeners like you who make it possible. Lucas: Yeah, if you find yourself thinking about yield curves or inflation data differently because of this conversation, that's the best feedback we could get. And if you want to support the show, you can do that at buy me a coffee dot com slash fexingo. No pressure, just an option if you value what we do. Luna: Absolutely. So, back to the curve — we've established that the inversion is more about global safety demand than recession fears. But there's another layer: the Iran energy spike. Oil prices have been volatile, and that feeds into inflation expectations. How does that complicate the yield curve read? Lucas: It adds a supply-shock dimension. Higher energy prices push up near-term inflation expectations, which keeps the short end elevated. But they also suppress growth expectations because they act like a tax on consumers. That pushes down long-term yields. So the inversion gets deeper. The Fed has to decide whether to look through the energy spike or respond. So far, they're looking through it, which is why the curve stays inverted. Luna: So the Iran situation is actually reinforcing the inversion, not breaking it. Lucas: Exactly. And that means the signal is even harder to interpret. A recession signal mixed with a supply-shock signal. The Fed's approach is to ignore the noise and focus on core inflation and labor market tightness. That's a reasonable approach, but it requires patience — from the Fed, from markets, and from listeners trying to make sense of it all.