Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / What Falling Bond Yields Say About Recession Odds
Transcript
- Lucas: The S&P 500 closed at 7,531 yesterday, up 3.6 percent in five days, and the Dow is north of 52,000 for the first time ever. Luna: Yet the ten-year Treasury yield dropped to 4.43 percent, down 12 basis points in a week. That is a pretty loud divergence. Lucas: Exactly. Stocks are cheering a goldilocks narrative — growth that's solid but not too hot, and a Fed that might cut rates later this year. But bonds are screaming something else. Falling yields in an environment where inflation is still running at 4.2 percent, and the Fed funds rate is 3.6 percent? That's a bond market pricing in a downturn. Luna: So which market is right? Because they can't both be right indefinitely. Lucas: That's the question we're going to drill into today. Let's start with the bond market's logic. The ten-year yield falling when inflation is sticky historically signals that investors expect growth to slow — potentially to recession levels. The yield curve has been inverted for over two years, and now it's uninverted, but that typically happens because short-term rates are falling faster. That's not what's happening now. Short-term rates are basically flat. The two-year yield is around 4.15 percent, down slightly, but the move is being led by the long end. Luna: Right, so the curve is steepening because long-term rates are falling, not because the Fed is cutting. That's a classic recession signal. Lucas: It is. And it's actually a more reliable signal than the inversion itself. Inversions are common and can persist for years. But once the curve starts to normalize — or un-invert — because the long end is dropping, recession tends to follow within six to twelve months. That happened before the 1990, 2001, and 2008 recessions. The question is whether this time is different. Luna: And the stock market is essentially betting that it is different. The S&P 500's recent rally is broad-based — it's not just a handful of AI stocks anymore. Small caps are up, the Russell 2000 gained 4.3 percent in five days. That suggests genuine optimism about the economy. Lucas: But look at the underlying data. Real GDP grew at an annualized rate of just 1.6 percent in the first quarter of this year, up from 0.5 percent in the prior quarter, but that's still below trend. Meanwhile, CPI hit 4.2 percent year-over-year in May, the highest in three years. The Fed is stuck. They can't cut rates with inflation that high, but if they hold rates steady at 3.6 percent, the real fed funds rate — adjusted for inflation — is negative. That's actually accommodative, not restrictive. Luna: Which is a weird place to be. The economy is supposed to be slowing, but policy is effectively loose. That's part of why the bond market is confused. Lucas: Let's bring in another data point. The JOLTS report for April showed job openings surged to 7.6 million, up from 6.9 million in March. That's a big jump. It suggests labor demand is still strong, which should support consumer spending and GDP. But initial jobless claims ticked up to 229,000, and the unemployment rate is 4.3 percent, which is a full percentage point above the cycle low. So the labor market is sending mixed signals too. Luna: It feels like every indicator is contradictory. The PCE price index is at 130.9, still rising, but core PCE is a bit lower. The 10-year breakeven inflation rate is 2.32 percent, which is right around the Fed's target. So the bond market is actually not pricing in runaway inflation. They're pricing in a slowdown. Lucas: That breakeven rate is key. The 10-year breakeven implies that investors expect inflation to average around 2.3 percent over the next decade. That's not far from the Fed's target. So the bond market doesn't think current inflation is persistent. They think the economy will cool enough to bring inflation down naturally, which is why they're buying long-term bonds and driving yields lower. The stock market, on the other hand, seems to think the economy can grow at a decent clip without reigniting inflation. Luna: Someone is going to be wrong. Historically, when stocks and bonds diverge this sharply, the bond market tends to be right about the direction of the economy. Stocks are more prone to recency bias and momentum. Lucas: That's a fair point. But we should also consider the possibility that both markets are pricing in different parts of the same story. Stocks might be reflecting the fact that the economy isn't in a recession yet — corporate earnings have held up, consumer spending is still positive. Bonds are looking six to twelve months ahead. So it's not necessarily a contradiction; it's just a difference in time horizons. Luna: That's a generous interpretation. But even if stocks are rallying on near-term strength, the bond market is saying the medium-term outlook is deteriorating. If that's right, the current rally could be a head fake. Lucas: And that's the risk. The fed funds rate is 3.6 percent, and the economy is growing at 1.6 percent annualized. That real rate of about 2 percent might not be high enough to quash demand, but it's high enough that any negative shock — like the geopolitical uncertainty we're seeing with the Iran situation and the UK economy shrinking — could tip things over. Luna: Yeah, the UK economy shrank 0.1 percent in April, and the ECB just hiked rates for the first time since 2023. Global tightening is still happening. That adds headwinds. Lucas: And wholesale prices jumped 1.1 percent in May, more than expected, largely on energy. That's going to feed through to consumer prices in the coming months, making the Fed's job even harder. So the floor on inflation is actually rising, not falling. Luna: Which makes the bond market's bet on disinflation look bold. Lucas: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. No ads, no sponsors. If walking through the economy with us has made something click, that's the button that keeps us independent. Luna: It really does. We put every dollar into research and production. So if you get value from these daily conversations, consider joining that group. Lucas: Alright, back to the divergence. Let's frame this with a concrete scenario. Suppose the bond market is right — that growth slows enough to bring inflation down to 2.5 percent by year-end. The Fed could then cut rates in late 2026 or early 2027. That would be a soft landing. But if inflation stays above 3 percent, the Fed can't cut, and the economy eventually cracks. That's a hard landing. The stock market seems to be pricing the soft landing. The bond market is pricing the early stages of a hard landing. Luna: And the data we have right now — 4.2 percent CPI, 4.3 percent unemployment, 1.6 percent real GDP growth — doesn't obviously favor one over the other. It's a coin flip. Lucas: It is. But the bond market has a better track record at inflection points. In mid-2000, stocks were still rallying while the yield curve started to un-invert. By early 2001, we were in recession. In late 2007, stocks hit an all-time high while the bond market was signaling stress. We know what happened next. So while I'm not predicting a recession tomorrow, the bond market's signal deserves respect. Luna: So what should an investor or a business owner do with this information? Lucas: I think the most practical takeaway is to acknowledge the uncertainty and avoid making big directional bets. If you're a business, it might be a good time to lock in longer-term debt while yields are still relatively low — before they fall further or spike if inflation reaccelerates. For investors, it's about diversification. Don't assume the stock market rally is telling you the whole story. Luna: And watch the next CPI and PCE reports closely. If we get another hot print, the bond market's recession call might fade, and yields could jump back up. If it comes in cooler, the bond market wins. Lucas: Exactly. The next two months of data will be decisive. The Fed's meeting in July will have updated projections. If they signal a willingness to cut even with inflation above target, that would validate the stock market's optimism. But if they stay hawkish, the bond market's view gains credibility. Right now, we're in the messy middle, and both markets are making reasonable but incompatible bets. Luna: We'll keep tracking it. In the meantime, we'll have more episodes breaking down the data as it comes. Thanks for being here.