Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Yield Curve Normalization Is Different This Time
Transcript
- Lucas: The yield curve is finally normalizing after nearly three years inverted, but this time it comes with a jobs report that added only 57,000 positions in June. That combination—flattening curve, weak hiring—normally screams recession. But I'm not sure that's what we're seeing. Luna: Right, because the old rule was always that an inverted curve predicts a recession within twelve to eighteen months. But we've been inverted since mid-2023, and here we are in July 2026 with GDP still growing at 2.1 percent. Lucas: Exactly. The 10-year Treasury is at 4.49 percent today, the 2-year at 4.23 percent—so a positive spread of about 26 basis points. That's a big shift from late 2023 when the inversion hit over 100 basis points. But the context is totally different from past cycles. Back in 2006, when the curve uninverted, the housing bubble was still inflating. In 2019, it uninverted and we got a manufacturing recession that turned into a pandemic crash. Luna: So what's different this time? The Fed is sitting at 3.63 percent, not cutting, not hiking. And the jobs market is cooling—57,000 in June is well below the six-month average. Lucas: That's the key. The Fed is stuck because core PCE is still running at 2.9 percent—down from 3.4 percent earlier this year, but above their 2 percent target. They can't cut without risking a reacceleration. But they also can't hike because the labor market is softening. So the curve is normalizing not because the economy is about to boom, but because the market is pricing in a prolonged period of slow growth and sticky inflation—stagflation-lite, if you will. Luna: And that's why the 10-year yield hasn't collapsed despite weak jobs data. Usually, a bad jobs report sends yields lower on rate-cut expectations. But the 10-year actually ticked up 2.6 percent over the past five days to 4.49 percent. Lucas: Because the market is also looking at that labor force participation rate dropping to levels not seen since the 1970s outside of COVID, and thinking: that's a supply constraint. Fewer workers means upward pressure on wages—average hourly earnings are up 2.4 percent year-over-year—and that keeps inflation sticky. So bonds are demanding a higher term premium for holding longer-dated debt. Luna: The term premium has been negative for most of the last decade. If it turns positive again, that alone could keep the 10-year elevated even if the Fed cuts. Lucas: And that's the part that makes this normalization different. Historically, the curve steepens because the front end falls faster than the long end—the Fed cuts aggressively. This time, the front end is pinned by a Fed that can't move, and the long end is rising because of term premium, not growth expectations. The 10-year breakeven inflation rate is 2.23 percent—almost exactly where it was six months ago. So inflation expectations are stable, but the real yield is going up. Luna: That suggests the bond market isn't worried about deflation or a crash. It's worried about being stuck with low nominal yields while inflation stays above target. Lucas: Exactly. The playbook from the 2000s and 2010s isn't useful here. This is a scarce-labor, sticky-inflation, low-productivity-growth environment. And if the curve continues to steepen while the Fed holds, it could actually be a signal about fiscal dominance—more Treasury issuance to fund deficits, which pushes long yields higher. Luna: So is the yield curve still a reliable recession indicator, or is it broken? Lucas: I think it's more nuanced than broken. The inversion part worked—it told us that monetary policy was restrictive. But the uninversion part usually comes when the Fed starts cutting. This time, the curve is steepening because the market is pricing in a longer period of tight policy, not a pivot. That's a different signal. It's saying the economy is slowing but inflation is sticky, and the Fed is boxed in. Luna: Which brings us back to the 57,000 jobs number. If that becomes the new trend, the Fed will have to choose between fighting inflation and supporting employment. Lucas: And historically, the Fed has chosen employment. But this time, the memory of the 2021-2022 inflation spike is fresh. They might tolerate a slower labor market to make sure they don't lose credibility. The dot plot from June still shows one cut this year, and the market is pricing in maybe two. But every time the data softens, yields don't fall—they rise because the term premium adjusts. That's a regime change. Luna: Speaking of the show's longevity, one quick thing that's been on my mind—this is our 96th episode, and we've never run ads. That's unusual for a daily podcast. Lucas: It's true. We keep the whole thing ad-free, and that's entirely because a small group of listeners chip in monthly. If walking through the economy with us has made something click, you can find us at buy me a coffee dot com slash fexingo. No pressure—it's just what keeps the lights on. Luna: And we mean that. It's a listener-funded show, and we're grateful for every one of you, whether you contribute or not. Now, back to the curve—what would it take for the Fed to actually cut? Lucas: Two things: either a clear drop in core PCE toward 2.5 percent, or a jump in the unemployment rate above 4.5 percent. Right now, unemployment is at 4.2 percent, ticking down from 4.3 percent. That's not alarming. And the JOLTS data from May showed 7.6 million job openings, basically flat. So the labor market is cooling, not collapsing. Luna: But if we look at the small-cap index, the Russell 2000 is down 0.5 percent over the past five days while the S&P 500 is up 1.8 percent. That divergence suggests the broad economy is weaker than the mega-cap stocks suggest. Lucas: That's a good point. The Russell is more sensitive to domestic growth and credit conditions. If small companies are struggling, that's a leading indicator. Combine that with the yield curve signal, and I think the risk is that the economy drifts sideways—not a recession, not a recovery, just a long, slow grind. And that's actually harder for the Fed to navigate than a clear downturn. Luna: Because in a recession, they cut aggressively and the curve steepens as the front end falls. In a grind, they're stuck. Lucas: Exactly. And the bond market is already pricing that in. The 10-year at 4.49 percent, the 30-year at 4.99 percent—that's not a recession curve. That's a curve that says 'we're not sure where growth and inflation are going, but we want to get paid for uncertainty.' Luna: So the uninversion might not be a recession signal this time—it might be a stagflation signal. Lucas: That's the thesis. The curve is normalizing because the term premium is coming back, not because the Fed is easing. And until we see either a clear disinflation trend or a labor market breakdown, that's the environment we're in. The next CPI report on July 15 will be huge. If core CPI, which is at 336.1, shows a month-over-month decline, that could break the logjam. Luna: Something to watch. Thanks, Lucas. Lucas: Thanks, Luna. See you tomorrow.