Fed's Internal Divisions Keep Yield Curve Tightly Compressed—A Flattening Trade Emerges

The Federal Reserve's latest FOMC minutes, released on July 6, revealed a deepening divide among policymakers over whether to cut rates in 2025 and how to interpret inflation dynamics. While most officials acknowledge eventual rate cuts are likely, the timing and conditions remain contentious. This internal tension has created a fertile environment for bond market volatility, with short-term yields anchored by delayed policy easing and long-term rates pressured downward by slowing growth. The result? A historically compressed yield curve that is ripe for a strategic flattening trade.

The Fed's Divided Outlook: A Stance Anchored in Caution

The minutes highlighted a stark split between policymakers who advocate for patience and those pushing for preemptive easing. A minority, including officials like Waller and Bowman, argued for a July rate cut to counteract tariff-driven inflation risks, while a larger bloc (4–5 members) opposed any cuts this year, citing persistent price pressures and strong labor market data. This divergence reflects a broader struggle within the Fed to balance inflation risks against growth concerns.

The majority's reluctance to cut rates soon has kept short-term yields elevated. The 2-year Treasury yield, which tracks near-term policy expectations, has remained stubbornly high at 4.8% as of July 7—above the Fed's projected neutral rate of 4.4%. This disconnect suggests markets are pricing in a slower easing path than the Fed's own forecasts, creating a gap investors can exploit.

The Transient Inflation Narrative: Cracks but No Collapse

Fed officials continue to frame much of the recent inflation surge as temporary, particularly pressures tied to tariffs and geopolitical disruptions. The minutes noted that while these risks are “manageable,” they cautioned that prolonged uncertainty could eventually destabilize inflation expectations. However, the staff's updated projections—lower inflation and higher GDP growth—suggest the Fed's optimism is holding.

This cautious optimism has kept long-term rates anchored at lower levels. The 10-year Treasury yield, which reflects growth and inflation expectations, has slipped to 5.2% amid softening activity in housing and manufacturing. The yield spread between 2-year and 10-year Treasuries, now just 0.4%, is the narrowest since early 2023, underscoring the market's belief that the Fed's delayed easing will ultimately clash with economic reality.

Political Pressures and the Growth Slowdown

While the minutes did not explicitly mention political pressures, the Fed's hesitation to cut rates contrasts with broader economic headwinds. Consumer spending and business investment have cooled as households grapple with higher borrowing costs, and corporate profits face margin squeezes from elevated wage growth. The Fed's staff projects GDP growth of 1.8% for 2025—down from 2.1% in their April forecast—a sign that the economy is slowing without yet triggering a recession.

This slowdown, combined with subdued wage growth, is likely to keep long-term rates under downward pressure. Meanwhile, the Fed's “data-dependent” mantra means short-term rates will remain elevated until inflation convincingly retreats or a recession becomes imminent. The result? A yield curve that continues to flatten, offering a clear trade opportunity.

The Case for a Flattening Trade: Short 2Y, Buy 10Y

The most compelling strategy in this environment is to short 2-year Treasuries and buy 10-year Treasuries, a classic flattening trade. Here's why:
- Short 2Y: The Fed's internal divisions ensure short-term yields stay elevated. Even if a cut occurs by year-end, the market's pricing of a delayed path (e.g., 4.5% by December) leaves room for a 2Y sell-off.
- Buy 10Y: Slowing growth and anchored inflation expectations will keep long rates lower. A 10-year yield of 5.0% or below by year-end is plausible, boosting bond prices.

Historically, such trades have thrived in environments where central banks err on the side of caution. The Fed's July minutes confirm it is not yet ready to pivot, even as economic data edges toward softness.

Risks to the Trade

• Inflation Surprises: If core services inflation (e.g., rents, healthcare) spikes unexpectedly, the Fed's hawkish minority could gain influence, lifting short rates.
• Political Catalysts: A sudden easing of trade tensions or fiscal stimulus could accelerate growth and widen the yield spread.

Conclusion

The Fed's internal divisions have created a policy limbo that is compressing the yield curve to extreme levels. While short-term yields linger near 4.8%, long-term rates are being dragged down by the reality of a slowing economy. Investors who bet on this flattening—by shorting 2-year Treasuries and buying 10-year bonds—position themselves to profit from the Fed's caution. As the minutes show, the path to easing remains uncertain, but the market's pricing of a delayed journey is the clearest roadmap for bond traders.