Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Yield Curve Inversion Tells Us Now
Transcript
- Lucas: The yield curve is inverted. It has been inverted for over two years now — the longest stretch since the 1970s. And yet, here we are in May 2026, no recession, the S and P 500 at 7,473, the Dow at 50,580. Luna: Right. So the classic recession signal has been flashing red for 800-plus days, and the economy just keeps chugging. Does that mean the indicator is broken? Lucas: That's the question everyone's asking. But I think the answer is more nuanced. The yield curve inversion — specifically the gap between the 2-year and the 10-year Treasury — has predicted every recession since the 1960s. It inverted in late 2022 and stayed inverted through 2023, 2024, 2025, and now into 2026. Luna: And right now, the 2-year is yielding about 3.59 percent, the 10-year is at 4.56 percent. So the spread is roughly 97 basis points — wait, that's positive. I thought you said inverted? Lucas: Good catch — but we're talking about the most commonly watched spread, which is the 2-year versus the 10-year. That spread is actually positive right now, around 97 basis points. The inversion I'm referring to is the 3-month versus the 10-year, which is still inverted, and also the 2-year versus the 10-year was inverted for a long stretch. It's only recently that the 2-10 spread has turned positive. Luna: Okay, so the 2-10 spread has normalized, but the 3-month to 10-year is still inverted. And that's actually the spread that the New York Fed uses in its recession probability model. Lucas: Exactly. The New York Fed's model, which uses the 3-month to 10-year spread, currently puts the probability of a recession in the next twelve months at about 30 percent — down from over 60 percent a year ago. So the curve is actually steepening, but it's still inverted on the short end. Luna: So the bond market is saying: near-term risk is elevated, but not imminent. And the fact that the 2-10 spread has gone positive suggests the market expects the Fed to start cutting rates later this year. Lucas: Right. The Fed's current rate is 3.64 percent on effective fed funds. The market is pricing in roughly two quarter-point cuts by year-end. But here's the rub: inflation is still sticky. The April CPI came in at 332.4, up from 330.3 in March. Core CPI is at 335.4, up from 334.2. That's not the kind of data that screams 'cut rates'. Luna: So the market is betting the Fed will cut even though inflation hasn't hit the 2 percent target. That seems like a recipe for another inflation surge. Lucas: That's the central tension right now. Kevin Warsh, the Fed chair, has been very clear: he's not cutting until he sees sustained progress on inflation. But the bond market is essentially calling his bluff. They're pricing in cuts because they think the economy will slow — or maybe because they think the Fed will cave under political pressure. Luna: Which brings us back to the yield curve. If the 3-month to 10-year spread remains inverted, it's still a recession signal. But maybe this time the signal is about something else — maybe it's about the Fed being behind the curve on cuts, not on hikes. Lucas: That's a really interesting framing. Normally, an inverted yield curve means the market thinks the Fed is too tight and will need to cut aggressively to avoid a recession. But if the cuts don't come, the curve stays inverted. And if the cuts come too late, the recession happens anyway. Luna: So what do you see as the most likely path from here? Does the curve disinvert fully before the Fed acts, or does the Fed act first? Lucas: Historically, the curve tends to steepen — meaning the inversion unwinds — before the first cut. That's what we're seeing now. The 2-10 spread has already turned positive. The 3-month to 10-year spread is still negative but narrowing. If that spread turns positive, the recession probability drops further. Luna: But it's worth noting that the curve can stay inverted for a long time. In the late 1970s, it was inverted for over a year before the recession hit in 1980. And in 2006-2007, it inverted for nearly two years before the financial crisis. Lucas: Exactly. The inversion is a leading indicator, but the lead time can be measured in years. So the fact that we haven't had a recession yet doesn't mean the signal was wrong — it might just mean the recession hasn't arrived yet. Luna: And of course, there's the complicating factor that the Fed is also running quantitative tightening, which affects the term premium. Some analysts argue that QT has kept long-term yields artificially high, which actually steepens the curve. Lucas: That's a great point. The Fed is still reducing its balance sheet, though at a slower pace. The interest on reserve balances is at 3.65 percent. So the short end is anchored by the fed funds rate, while the long end reflects both inflation expectations and term premium. The 10-year breakeven inflation rate is 2.40 percent, up from 2.39, so inflation expectations are fairly stable. Luna: Stable but elevated — 2.4 percent is above the Fed's 2 percent target. So the bond market is essentially saying: we expect inflation to stay above target, but we also expect the economy to slow enough to warrant rate cuts. Lucas: That's the Goldilocks scenario — a soft landing. And if you look at the equity market, the Russell 2000 is up 3.4 percent in the last five days, the Dow up 1.8 percent. Small caps are particularly sensitive to interest rates, so that rally suggests investors think the worst of the tightening is behind us. Luna: But consumer sentiment hit a record low last week. So the disconnect between Main Street and Wall Street is as wide as ever. Lucas: That's the elephant in the room. The economy is in this weird place where the aggregate numbers look okay — GDP is still positive, unemployment is low — but the consumer is really feeling the pinch. Inflation may be down from its peak, but price levels are still high, and wages haven't kept up. Luna: So if the consumer is hurting, and the Fed is holding rates steady, and the yield curve is still partly inverted, what's the catalyst that breaks this logjam? Lucas: The most likely catalyst is a further weakening in the labor market. If we start to see jobless claims rise consistently or payrolls come in below 100,000, the market will start pricing in more aggressive cuts. And at that point, the Fed might feel compelled to act. Luna: Or a further escalation in the Iran conflict could send oil prices higher, which would make the inflation problem worse and force the Fed to stay on hold, or even hike. Lucas: Right. So the yield curve is basically a tug of war between growth fears and inflation fears. Right now, growth fears are winning on the long end, but inflation fears are keeping the short end elevated. That's why the curve is still inverted. Luna: It's fascinating — and a little unsettling — that the most reliable recession indicator is flashing but the recession hasn't arrived. It really drives home the point that central banking is as much an art as a science. Lucas: Speaking of which, let me say something here. We talk about the Fed and the bond market a lot on this show. And one thing we're proud of is that we don't run any ads. No sponsored segments, no commercials. We keep it ad-free because we want you to get the analysis without any of that noise. Luna: Yeah, it's a deliberate choice. And if listening to us walk through the economy has made something click for you, you can support the show at buy me a coffee dot com slash fexingo. Lucas: Exactly. It's a simple way to keep the show going and ad-free. And we appreciate every bit of support. So back to the curve — the real question is whether this inversion ends with a recession or a pivot. Luna: And we'll be watching the June FOMC meeting closely. That's in about two weeks. The market is pricing in a 15 percent chance of a cut, but the data between now and then could change that. Lucas: Right. The next CPI report comes out before the meeting, and that could be the deciding factor. If inflation surprises to the downside, we could see the curve steepen further and the recession probability drop. If it comes in hot, the curve might invert more deeply. Luna: So the yield curve is still the best single indicator for where the economy is headed — it's just that the message is more complicated than 'recession coming' or 'no recession'. Lucas: Exactly. It's telling us that the economy is at a crossroads. And Kevin Warsh has to navigate that without a clear map.