Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / What the Yield Curve Inversion Says About Recession Risk Now
Transcript
- Lucas: The yield curve has been inverted for over two years now, and the bond market is still sending a message that a lot of investors are misreading. Luna: It feels like every few months someone declares the recession signal is dead. But the curve is still inverted, just in a different shape. Lucas: Exactly. Look at the numbers from Friday. The 10-year Treasury closed at 4.54 percent. The 2-year yielded 4.28 percent. So you've got a 26-basis-point inversion. That's still deep by historical standards. Luna: And the fed funds rate is at 3.62 percent. So the entire short end is below the long end — but not by much. Lucas: The classic warning is a 2-year versus 10-year inversion. But there's also the 3-month versus 10-year spread, which is inverted too. The 3-month bill is at 3.62, the 10-year at 4.54 — that's a 92-basis-point inversion. Luna: That's a bigger inversion than the 2-10 spread. Usually the 3-month to 10-year is the one economists watch for recession signals. Lucas: Right. And historically, once that spread inverts, a recession follows within 12 to 18 months. But we've been inverted since late 2022. That's more than three years. No recession yet. Luna: So what's different this time? Is it just that the economy is stronger, or is the signal broken? Lucas: I think the signal is telling us something, but it's not a simple binary 'recession or no recession.' The inversion reflects expectations that the Fed will have to cut rates because growth slows. But the cuts haven't come because inflation has been sticky. Luna: Right — core PCE is still at 3.3 percent. The Fed can't cut aggressively without reigniting inflation. Lucas: And that's the twist. Normally when the curve inverts, the Fed cuts rates quickly, the curve steepens, and the economy recovers. This time, the Fed is stuck. They cut 25 basis points in March, but then paused. The daily fed funds rate is 3.62 percent. Luna: So the inversion persists because the market is pricing in future cuts that haven't happened yet. It's like the bond market is waiting for the Fed to catch up. Lucas: Bingo. The 10-year yield has actually risen 1.4 percent in the last five days. That's the market pricing in higher growth or inflation expectations. Meanwhile, the 2-year has stayed relatively flat. Luna: So the curve is actually steepening — becoming less inverted — but still inverted. That's a subtle signal. It could mean recession risk is fading, or it could mean the market is just adjusting to delayed cuts. Lucas: Let's look at real GDP growth. The annualized rate for the first quarter of 2026 was 1.6 percent. That's up from 0.5 percent in the prior quarter, but it's still below trend. The economy is growing, but barely. Luna: And nominal GDP is $31.8 trillion. That's a lot of output, but real growth of 1.6 percent is sub-2 percent. That's not recession territory, but it's not booming either. Lucas: The job market is still adding jobs. Nonfarm payrolls hit 159 million in May. That's up from 158.8 million in April. But look at the details: job openings surged to 7.6 million in April from 6.9 million in March. That's a big jump. Luna: So the labor market is still tight. But long-term unemployment is rising. We covered that last week. There's a split in the data. Lucas: Right. The headline unemployment rate is stuck at 4.3 percent. But initial jobless claims are creeping up — 225,000 last week from 212,000 the week before. That's the highest level since last fall. Luna: So the bond market might be seeing a slower economy ahead. But the stock market isn't panicking. The S&P 500 is at 7,384, down 2.8 percent over five days, but that's a modest pullback from highs. Lucas: The Nasdaq is down more — 5.1 percent in five days. That's a sharper drop, probably tech profit-taking. But the Dow is only down 0.4 percent. So the rotation is happening. Cyclicals and value are holding up better than growth. Luna: That fits the narrative of a slowing economy where defensive sectors outperform. But if a recession were imminent, you'd expect the Dow to be down more. Lucas: Let's step back. The yield curve inversion has been a reliable recession indicator for decades. But the economy has changed. The relationship between short-term rates and long-term rates is influenced by a lot more factors now — global capital flows, QE unwind, term premiums. Luna: And the Fed has a bigger balance sheet than before. The interest on reserve balances is 3.65 percent. That acts as a floor for short rates and changes how the curve behaves. Lucas: Still, I think the inversion is a warning, not a false alarm. The risk is that the Fed keeps rates too high for too long, and the economy tips over. The 10-year yield rising while the short end stays flat is a sign that long-term investors are demanding more compensation for holding bonds. Luna: That could be because of the fiscal deficit. The Treasury is issuing a lot of debt. The 10-year breakeven inflation rate is 2.36 percent, which is stable. So it's not inflation expectations driving the long end higher. Lucas: It's the term premium — the extra yield investors require to hold long-term bonds because of supply and uncertainty. If that keeps rising, mortgage rates and corporate borrowing costs stay high, even if the Fed cuts. Luna: And that's the real risk. Not a recession from the yield curve per se, but a financial conditions tightening that chokes off growth. Lucas: Before we get too deep into that — and I want to come back to it — I want to mention something. We don't run ads on these daily episodes. No sponsor breaks, no prerecorded spots. That's intentional. We want the conversation to flow without interruption. Luna: It does make a difference. You can actually follow the argument without being pulled out every ten minutes. Lucas: If listening to us walk through the economy has helped you make sense of things, the only way we keep this ad-free is through listener support. There's a link at buy me a coffee dot com slash fexingo. No pressure, just an option if you find value in it. Luna: Yeah, it helps us keep the lights on and the podcasts independent. Lucas: Alright, back to the term premium. Let's look at what it means for the housing market. The 10-year is at 4.54 percent. That's up from 4.47 percent a week ago. Mortgage rates are roughly following that, so 30-year fixed rates are probably around 6.8 to 7 percent. Luna: And housing inflation is still a big piece of the CPI. Shelter costs are sticky. The Fed can't cut rates enough to ease housing without reigniting demand and prices. Lucas: It's a trap. If the Fed cuts to steepen the curve and normalize the yield curve, they risk fueling more inflation in housing and services. If they hold steady, the curve stays inverted and the economy slows. Luna: So what does that mean for the next few months? The May jobs report comes out this Friday. That's the next big data point. Lucas: Expectations are for payroll growth of around 180,000 to 200,000. If it comes in much weaker, the bond market will read that as confirmation that the economy is slowing, and the curve might steepen further on rate-cut expectations. Luna: And if it's stronger, then the Fed stays on hold, the curve stays inverted, and the recession debate continues. Lucas: My view is that the yield curve is not wrong this time, but the timing is stretched. The economy is slowing, but slowly. The inversion is a sign that we're in the late cycle. It's not a screaming alarm for next quarter, but it's a reason to be cautious. Luna: So for investors, it's about positioning. Maybe shorter duration bonds, or defensive sectors, or just being more liquid. Lucas: Exactly. And keeping an eye on the 10-year yield. If it breaks above 4.75 or 5 percent, that's a signal that term premium is really ramp up. That would be a bigger story than the inversion itself.