Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Yield Curve Is Uninverting Without a Recession
Transcript
- Lucas: So the yield curve has been inverted for nearly three years now. We are currently living through the longest stretch of an inverted 2-10 year spread in modern history. Luna: And yet, here we are. No recession. GDP is still growing, unemployment at 4.3 percent. The old rule that an inverted curve means recession within 12 to 18 months has clearly broken down. Lucas: Yeah, it's become one of the most debated signals in macro right now. Let's start with the basics for anyone who hasn't followed this closely. The yield curve is simply the difference between long-term and short-term Treasury yields. When short-term rates are higher than long-term rates, that's an inversion. Historically, it has preceded every US recession since the 1960s. Luna: But not this time. At least not yet. The curve inverted in late 2022 and stayed inverted through 2023, 2024, 2025. And now in June 2026, it's starting to steepen a bit. The ten-year is at 4.55 percent, the two-year is around 4.28 percent. That spread is still negative, but it's narrowing. Lucas: Right, the two-year yield is actually lower than the ten-year by about 27 basis points as of this morning. That's still inverted, but compare that to the deepest point of the inversion in mid-2023 when we saw negative 100 basis points or more. The curve is slowly normalizing. Luna: So what changed? Why is the curve starting to steepen now? Lucas: A few things. First, the market is pricing in rate cuts from the Fed later this year. The Fed funds rate is currently at 3.62 percent, effectively. The two-year Treasury is highly sensitive to Fed policy expectations, so as traders anticipate cuts, the two-year yield comes down. That narrows the inversion from the short end. Luna: Meanwhile, the ten-year yield is being driven by different forces: inflation expectations, term premium, fiscal deficit concerns. It hasn't fallen as much. Lucas: Exactly. The ten-year yield has actually been stubbornly high. The 10-year breakeven inflation rate is around 2.35 percent, so inflation expectations are anchored but not low. And there's the term premium — the extra compensation investors demand for holding longer-term bonds. That premium has turned positive again after being negative for years. Luna: So the yield curve is steepening not because the economy is about to boom, but because the short end is falling on rate-cut expectations and the long end is staying elevated on supply and term premium. Lucas: That's the key nuance. A steepening curve can mean two very different things. One is a 'bull steepener' where long-term yields fall faster than short-term — usually signaling a growth scare. The other is a 'bear steepener' where long-term yields rise. What we're seeing right now is more of a hybrid. Short-term yields are falling gradually, long-term yields are holding steady. Luna: Let's talk about the recession signal itself. Why did the curve invert for so long without a recession following? Lucas: There are a few theories. One is that quantitative easing and the Fed's large balance sheet distorted the term premium for years. Another is that global demand for US Treasuries, especially from foreign central banks, has kept long-term yields artificially low, making the curve flatter than it would be otherwise. But perhaps the most compelling argument is that the economy simply adjusted differently this cycle. The pandemic caused such a massive shock and recovery that the usual relationships broke down. Luna: I've also heard the argument that the inversion signal got weaker because the Fed started raising rates from near zero so quickly. The speed of the hiking cycle, rather than the level of rates, might have been what mattered historically. Lucas: Right, and some economists have pointed out that the inversion is not a perfect causal signal — it's a symptom of tight monetary policy. And tight policy can still cause a recession, just maybe with a lag. The average lag from inversion to recession has been about 18 months, but there's a wide range. Some have argued this time the lag could be longer because the economy had so much excess savings and pent-up demand. Luna: But those excess savings are now largely depleted. The personal saving rate has fallen below 4 percent. Consumer credit delinquencies are rising. So maybe the recession risk hasn't disappeared, it's just been delayed. Lucas: That's what makes this moment so interesting. The curve is starting to 'uninvert' just as the economy shows signs of softening. Real GDP growth annualized was only 1.6 percent in the first quarter, down from 2.4 percent at the end of last year. Jobless claims have ticked up. The New York Fed's household survey shows financial anxiety at a four-year high. Luna: So if the curve normalizes and we still avoid recession, that would be a historic 'soft landing'. But if the economy slips into recession later this year or in 2027, then the curve would have been right all along, just early. Lucas: Exactly. And the bond market is not pricing a recession right now. The current forward curve implies about three quarter-point rate cuts over the next 12 months, which is consistent with a gentle easing cycle, not an emergency. If a recession were imminent, we'd see the short end pricing in much deeper cuts. Luna: Hey, before we dig deeper into the recession scenarios — and I do want to get into that — I want to mention something that keeps these daily episodes going. A couple of dollars a month is genuinely what keeps the lights on here. If walking through the economy with us has made something click, buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing but it makes a real difference. No pressure, just if you've gotten value from these conversations. Now, back to the curve — let's talk about what the bond market is getting wrong. Luna: Alright. So you mentioned the forward curve pricing three cuts. But the Fed itself has been signaling only one cut in the second half of the year, if that. There's a disconnect. Lucas: There is. And historically, when the market and the Fed disagree, the market has been right about the direction of rates about 60 percent of the time. But the magnitude is often overdone. The market tends to price in a lot of cuts early, then have to walk them back if inflation stays sticky. Luna: And inflation has been sticky. Core PCE is running at 2.8 percent year-over-year, still above the Fed's 2 percent target. That gives the Fed cover to hold steady. Lucas: Right. So the yield curve is telling us two things at once. First, that the market expects the Fed to cut. Second, that long-term bond investors are still worried about inflation and fiscal deficits. That's not a classic recession signal. It's more of a 'muddle through' signal. Luna: So for an investor listening, what's the takeaway? Does the curve still matter? Lucas: I think the curve matters, but you have to look at the components, not just the spread. If the ten-year yield rises while the two-year falls, that's a very different environment than both yields falling. Right now, we're in a 'bear flattener' — wait, actually, we're in a 'bull steepener' if you consider the two-year falling more than the ten-year. It's getting technical. Luna: Let's keep it practical. The bottom line: the curve is normalizing but hasn't fully uninverted. Recession risk hasn't vanished, but the usual indicators are murky. Lucas: Exactly. And I think the most responsible take is that the yield curve is no longer the automatic recession signal it once was. The economy has evolved — the Fed's balance sheet, global capital flows, the structure of the bond market itself have all changed. We should still pay attention to it, but don't put all your chips on one indicator. Luna: And watch the ten-year yield. If it starts spiking above 5 percent without the Fed cutting, that would signal real trouble — either an inflation reacceleration or a buyer strike. Lucas: Yeah, the 30-year Treasury is at 5.02 percent already, just above that psychological level. That's worth monitoring. But for now, the curve is slowly unwinding, the economy is cooling gradually, and the Fed is waiting for more data. It's the definition of a wait and see macro environment. Luna: Good place to leave it for today. Thanks, Lucas. Lucas: Thanks, Luna. We'll keep watching the numbers.