Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Two-Year Yield So Closely
Transcript
- Lucas: So the two-year Treasury yield is sitting at four point six nine percent this week, up from four point six two a week ago, and the Fed is just... watching it. I think that number tells you more about where rates are heading than any single speech from a governor. Luna: Right, and it's moving even while the Fed hasn't touched the funds rate. What's driving that? Is it just the jobs report? Lucas: Partly. Friday's July report was genuinely soft — the economy lost twenty-three thousand jobs, and private payrolls added just forty-four thousand, per ADP. That's a labor market losing momentum. But the two-year yield isn't falling — it's rising. That's the interesting bit. Luna: So the bond market is saying this data won't force the Fed to cut soon? Lucas: Exactly. The two-year yield is the market's best guess at where the Fed funds rate will average over the next couple of years. It's up because traders are starting to price out deeper cuts. A couple of weeks ago, the strip was implying maybe two cuts by year-end. Now it's more like one, and even that's not a lock. Luna: But the jobs number was weak. Why would that push yields up? Lucas: Because the Fed is more worried about inflation staying sticky than about growth cratering. Core PCE ticked up to one thirty point three in June, and the ten-year breakeven rate moved from two point two five to two point two nine. That's the market telling you inflation expectations are creeping up, not down. Luna: So even with weak jobs, the Fed's hands are tied because inflation is still above target. Lucas: That's the bind. And the two-year yield is the cleanest read on how the market thinks the Fed resolves it. When the yield rises, it means traders expect the Fed to hold or even hike. When it falls, cuts are coming. That's why the Fed itself watches it so closely. Luna: We should also say — if you're getting something out of these episodes, there's a small group of listeners who keep the whole thing running by tossing a few bucks a month to buy me a coffee dot com slash fexingo. That's literally what funds making this many of these. Lucas: Yeah, and it keeps us independent and ad-free. We don't have to chase sponsors or twist the analysis to please anyone. So if you've ever learned something here, that's a way to keep it going. Luna: And we're back to the yield curve. Lucas, you were saying the Fed watches the two-year — but is that the same as the yield curve, or is that different? Lucas: It's related but distinct. The yield curve is the spread between the two-year and the ten-year. Right now, the ten-year is at five point two four, so the curve is actually steep — about fifty-five basis points positive. That's a sign the market expects growth and inflation to stay firm over the long run, even if the near-term path is uncertain. Luna: And a steep curve usually means the Fed has room to be patient, right? Lucas: Exactly. If the curve were inverted — you know, two-year above ten-year — that's historically been a recession warning. Right now it's not, which gives the Fed cover to hold rates where they are and wait for more data. They can say, look, the bond market isn't screaming recession, so we can keep our options open. Luna: But the two-year alone is what matters for the next few meetings, isn't it? Lucas: That's the thing. The two-year is the market's direct bet on Fed policy. The ten-year is more about long-term growth and inflation. So when you see the two-year rising, it's not about the election or fiscal policy — it's purely about what the Fed will do at the September and November FOMC meetings. And right now, it's telling you the bar for a cut is high. Luna: How does the Fed actually use that signal internally? Do they have a model or do they just eyeball it? Lucas: They track it closely, but not mechanically. A lot of the Fed research on the two-year yield shows it has predictive power for the funds rate over the next year or so. But the Fed also knows that the two-year can be distorted by term premiums and liquidity conditions, so they don't react to every basis point move. Luna: Still, when it moves this much in a week — up fifteen basis points — that's a signal worth talking about. Lucas: Absolutely. And it's not just the level, it's the direction. A week ago, the two-year was at four point six two. Now it's four point six nine. That's a meaningful shift in market expectations. And it's happening even as the jobs report was soft — which tells you the market is focusing on inflation risk, not growth risk. Luna: So what does this mean for someone with a mortgage or a car loan? Does a rising two-year yield translate to higher borrowing costs? Lucas: It can. The two-year yield influences short-term rates on things like adjustable-rate mortgages and some business loans. But for most consumer borrowing, it's the ten-year that matters — that's what fixed mortgage rates track. So the recent rise in the ten-year, from around five point one to five point two four, is actually the one to watch for homebuyers. Luna: And that's also the Fed's problem — they want to ease financial conditions, but the bond market is tightening them for them. Lucas: Exactly. The Fed has held the funds rate at three point six three for months now, but market rates are creeping up. That tightens policy without the Fed doing anything. It's like the market is doing the Fed's job for it, but in the wrong direction from what they'd want. Luna: But if inflation expectations are rising, maybe that's not wrong. Lucas: That's the debate inside the Fed. The doves would say the rise in breakevens is a blip — commodities and base effects. The hawks would say it's the wage-price spiral re-igniting. The two-year yield is the market's way of saying the hawks are winning the argument right now. Luna: So the next few weeks are crucial, especially with the September FOMC meeting coming up. What should we watch? Lucas: First, the August jobs report, which comes out in early September. If it's as weak as July's, the two-year might start pricing in a cut again. Second, the CPI data for July, which we'll get in a couple of weeks. If core CPI continues to decelerate — June was down from three thirty-three point nine eight to three thirty-two point six — that gives the doves ammunition. Luna: And the two-year yield will be the real-time scoreboard for that debate. Lucas: Exactly. You don't need to parse Fed speeches when you can just look at the two-year. It's the market's collective bet on what the Fed will actually do — and right now, it's saying 'hold steady, keep your powder dry.' Luna: It's a good reminder that the Fed doesn't operate in a vacuum — the bond market is a powerful force. Lucas: And that's why we keep coming back to it. Thanks for listening, and we'll be back next week with more on how the Fed thinks.