Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why Surging Yields Are Breaking The Fed Playbook
Transcript
- Lucas: We need to talk about the ten-year Treasury yield because it just refused to come down. It’s sitting at five point one eight percent right now, up nearly five percent over the last five days alone, and that is not a blip. This is the number that sets the tone for every mortgage, every corporate bond, and frankly, every decision the Federal Reserve makes from here until December. Luna: Right, and look at the S&P five hundred reacting to it with a zero point three percent drop; the market is already pricing in that this higher cost of capital is sticking around longer than anyone expected. Lucas: Exactly. So here is the concrete thing you should take away today: the Fed’s own short-term tool, the Fed Funds effective rate, is still hovering around three point six three percent, but the long end of the curve is demanding five point one eight percent. That gap tells us investors are telling the central bank they do not believe inflation will stay near target, regardless of what Powell says in his press conferences. Luna: It feels like we are seeing a loss of control over the forward guidance, doesn't it? Like the bond vigilantes have suddenly woken up. Lucas: They haven't just woken up, they are running the show. Let's look at the data from August. Core CPI came in at three hundred thirty seven point eight, which is still stubbornly above the two percent goal, and the ten-year breakeven inflation rate ticked up to two point three four percent. When investors demand two point three four percent just to compensate for expected inflation, adding a risk premium on top pushes those yields even higher. Luna: So if the Fed cuts rates next month, but yields keep rising, aren't they effectively tightening financial conditions anyway? Lucas: That is the exact trap Kevin Warsh pointed out yesterday. If the Fed eases policy while the market tightens credit conditions through higher long-term yields, you get a conflicting signal that confuses businesses and consumers. We saw headlines this week about global debt topping three hundred sixty five trillion dollars, which makes this dynamic even more dangerous for emerging markets. Luna: Three hundred sixty five trillion is a staggering number, especially when the cost of servicing that debt keeps climbing. Lucas: It is staggering. And before we dig too deep into the mechanics of why the bond market is rebelling, I want to pause for a second. If walking through the economy with us has made something click, or if you just appreciate having a clear, ad-free space to understand these complex shifts, please consider supporting the show directly. Luna: Yeah, we build these episodes because listeners like you keep the lights on, and it really does help us maintain the quality of the research we bring to the mic. Lucas: You can find us at buy me a coffee dot com slash fexingo. No pressure at all, just if it adds value to your week, we’d be grateful for the support. Now, back to the yield curve... Luna: Because there is another layer here regarding the Federal Reserve's balance sheet that people often miss. Lucas: Good point. Earlier this year, we talked about liquidity drains, but today the issue is different. The Treasury General Account is fluctuating, and when the government draws down cash reserves, it pulls liquidity out of the banking system. With the overnight repo rate sitting at three point eighty eight percent, banks are feeling that squeeze. Luna: So you have sticky inflation data pushing yields up, and less liquidity in the system making those high yields even harder to absorb? Lucas: Precisely. It creates a vicious cycle. Higher yields mean the US government pays more interest on its own debt, which widens the deficit, which means more supply of Treasuries, which pushes yields even higher. It is a self-reinforcing loop that the Fed cannot simply print its way out of without reigniting the very inflation they are trying to kill. Luna: And that is why the market is so jittery about the upcoming FOMC meeting. Everyone is waiting to see if they acknowledge this disconnect. Lucas: They might try to ignore it, but they can't hide from the numbers. Look at the PCE price index, the Fed's preferred measure. Core PCE was one hundred thirty point seven in July, up from one hundred thirty point three four. It is moving, slowly, but it is moving. And combined with the surging yields, the real economic activity is getting squeezed. Luna: It reminds me of the Swiss keeping rates at zero percent right now; they are playing a completely different game because their domestic inflation dynamics are so different from ours. Lucas: The Swiss are an outlier, but it highlights how fragmented global monetary policy is becoming. While Europe struggles with budget battles in places like France, and China sees surprise jumps in US orders ahead of diplomatic summits, the US is stuck managing this internal contradiction between short-term easing hopes and long-term rate realities. Luna: So what happens if the Fed tries to cut rates in September or October and the ten-year yield breaks five point five percent? Lucas: Then we enter uncharted territory where equity markets likely sell off further, exactly what we are seeing in the Russell two thousand with a one point three percent drop. Small caps are drowning in variable-rate debt, and if their borrowing costs jump that high, earnings estimates get revised down aggressively. Luna: Which brings us back to the wage-inflation trap we discussed a few episodes ago. If companies can't borrow cheaply, they freeze hiring, which slows wage growth, which eventually cools inflation, but only after a recession hits. Lucas: That is the soft landing scenario that is looking increasingly hard to land. The data suggests we are transitioning from a period of 'higher for longer' rates to a period of 'too high for comfort' yields. The market is pricing in a correction that hasn't happened yet, but the infrastructure for it is being built by these daily yield spikes. Luna: It’s fascinating how the VIX stays relatively calm despite all this tension. Do you think investors are complacent? Lucas: I think they are leveraged. When the VIX is low, it usually means everyone is positioned for the same outcome. But with the ten-year Treasury at five point one eight percent, the baseline assumption of cheap money is gone. You can't build a multi-year bull market on a foundation of five percent risk-free returns. Luna: So where do we go from here? Is there any data point that could convince the bond market to chill out? Lucas: A strong jobs report would actually make things worse in the short term because it gives the Fed cover to hold rates steady while yields climb. You need either a sharp drop in inflation data, like a surprise fall in the CPI to below three percent, or a sign of economic weakness so severe that the Fed is forced to panic-cut. Luna: Or maybe a shock from overseas, like another move by Japan or China, that forces a global reset. Lucas: Those geopolitical shocks are always in the wings. But for now, the focus remains on that ten-year yield. It is the anchor. If it stays above five percent, the entire asset allocation model changes. Equities become less attractive compared to bonds, and the rotation trade we’ve seen for years might reverse. Luna: It makes sense to watch the breakeven inflation rate closely. If that drops below two percent, it signals the market believes the Fed is winning the fight. Lucas: Right now it is at two point three four percent, which is a warning light. We are waiting for that light to turn green before we assume the worst is behind us. Until then, the playbook is broken, and the Fed is flying blind. Luna: It’s a reminder that monetary policy isn't just about what the central bank says, but what the bond market decides. Lucas: Absolutely. The bond market is the ultimate referee, and right now, they are calling fouls on the Fed almost every day. We will see if they change their tune next week, or if this new normal sticks around for the rest of the quarter. Luna: I suspect the latter, especially with global debt levels this high and nowhere to run. Lucas: Fair enough. We’ll keep watching the ten-year, the CPI, and the Fed Funds spread. Stay tuned, and let’s see where this yield curve takes us next.