Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the 2-Year Breakeven Rate
Transcript
- Lucas: If walking through the economy with us has made something click, there's a simple way to keep this going ad-free. Luna: Yeah, listener support is what keeps the lights on here at Fexingo Business. Lucas: Exactly. So if today was genuinely useful to you, buy me a coffee dot com slash fexingo. That's all, and it helps a ton. Luna: Alright, let's get back into it. So Lucas, you were saying the 2-year breakeven inflation rate is a cleaner signal than the 10-year. Lucas: Right. So the 2-year breakeven inflation rate is derived from the yield difference between a nominal 2-year Treasury and a 2-year Treasury Inflation-Protected Security, or TIPS. Luna: And why should the Fed care more about that than the 10-year breakeven? Lucas: Great question. The 10-year breakeven is the more commonly cited metric, but it's contaminated by term premium—investors demand extra compensation for holding longer-duration bonds, which muddies the inflation signal. The 2-year breakeven is much closer to a pure measure of where markets expect inflation to average over the next two years, with minimal term premium. Luna: So it's more like a 'nowcast' of inflation expectations. Lucas: Exactly. And right now, the 2-year breakeven is hovering around 2.6 percent. That's above the Fed's 2 percent target, and it's been stubbornly elevated even as headline CPI has moderated. The latest CPI print for May came in at 334.0, up from 332.41, which is about a 2.9 percent year-over-year increase. But core CPI, excluding food and energy, is at 336.1, up from 335.42, so that's still around 3.3 percent. Luna: So the market is basically saying inflation isn't going to fall to 2 percent anytime soon, even if the headline number looks better. Lucas: Right. And that's a problem for the Fed, because they've been signaling that they might cut rates later this year, especially after the June payrolls miss—only 57,000 jobs added, and the unemployment rate crept up to 4.2 percent. But if the 2-year breakeven stays above 2.5 percent, it's hard for the Fed to justify a cut without risking a de-anchoring of inflation expectations. Luna: And we saw the 10-year breakeven tick up to 2.24 percent from 2.23 percent last week—small move, but directionally consistent. The 2-year is probably even more sensitive to the recent data. Lucas: Yeah, the 2-year breakeven reacts more to each CPI and payrolls report because it's a shorter horizon. So after the May CPI came in a bit hot, the 2-year breakeven likely moved more than the 10-year. And that's exactly what the Fed's doves are worried about: if the market starts pricing in persistently higher inflation, it becomes self-fulfilling. Luna: Let's talk about the 'funflation' trend for a second. There was a headline about how staying in isn't the cost-saver it used to be. How does that play into inflation expectations? Lucas: It's interesting because services inflation—things like streaming subscriptions, food delivery, even at-home entertainment equipment—has been sticky. That's the kind of inflation that feeds into core PCE, which the Fed targets. The May core PCE price index is at 130.1, up from 129.67, so still running above trend. And if consumers are shifting spending from goods to services, that keeps services inflation elevated. Luna: So the 2-year breakeven is capturing that stickiness, while the 10-year might be dulled by longer-term expectations of a recession or something. Lucas: Exactly. And that's why I think the Fed is paying more attention to the shorter-dated breakevens now. Chair Powell mentioned in the last press conference that they're looking at a 'broad set of inflation expectations measures,' and I suspect the 2-year breakeven is one of them, even if they don't name it publicly. Luna: So what would it take for the 2-year breakeven to fall back toward 2 percent? Lucas: A few things. One, a sustained period of weak payrolls—like below 100,000 for several months—would signal the economy is softening enough to cool price pressures. Two, we'd need to see core PCE month-over-month prints come in at 0.1 percent or lower for a few months. And three, global factors like oil prices staying range-bound or falling. The 10-year breakeven is at 2.24, which is still above the Fed's target, but the 2-year is even higher. Luna: And the fed funds rate is at 3.63 percent effective. So real rates based on the 2-year breakeven would be about 1 percent—positive, but not extremely restrictive. Lucas: Right. If the 2-year breakeven were at 2 percent, the real fed funds rate would be 1.63 percent, which is more restrictive. So the market is essentially saying that current policy isn't tight enough to bring inflation down to target quickly. And that puts the Fed in a bind: cut rates and risk inflation staying hot, or hold steady and risk a sharper slowdown. Luna: And we've seen the yield curve inverted again—the 2-year note yields around 4.31 percent, the 10-year at 4.57 percent, so the inversion is narrowing. That's usually a sign that recession risk is receding, but inflation expectations are complicating the message. Lucas: Exactly. The curve is steepening because the long end is rising on inflation fears, not because the short end is falling on rate cut expectations. That's a bear steepener, and it's historically a bad omen for risk assets. The S&P 500 is at 7,575, up half a percent in the last five days, but the Dow is down 0.8 percent. So markets are mixed. Luna: So bottom line: the 2-year breakeven is the canary in the coal mine for the Fed. If it stays above 2.5 percent, we probably won't see rate cuts this year. Lucas: That's my read. Unless something breaks—like a credit event or a sharp downturn in the labor market—the Fed is likely on hold. The next CPI report in July will be crucial. If core CPI doesn't show meaningful progress, the 2-year breakeven could push toward 2.8 percent, and that would really rattle the bond market. Luna: And we'll be watching the Fed's next statement for any mention of 'elevated inflation expectations' as a signal they're worried about this exact metric. Lucas: Absolutely. The FOMC meeting is in late July, and the dot plot from June already showed most members expecting two cuts this year. But if the data keeps coming in hot, those dots could shift higher. The 2-year breakeven is the market's way of telling the Fed they're not done yet. Luna: Alright, that's a great framework. Thanks, Lucas. Lucas: Thanks, Luna. And thanks to our listeners for tuning in. We'll keep tracking these signals.