A critical Treasury yield gap has contracted to its tightest level in a year as markets position for potential Federal Reserve policy shifts. According to Bloomberg reports, the spread between five-year and 30-year yields has narrowed to approximately 81 basis points, marking the lowest level since May 2025. The compression reflects a broader selloff in shorter-dated Treasuries, which are more sensitive to Federal Reserve policy expectations. The gap between two- and 30-year yields has also narrowed to its tightest level since July as of Friday's close.
Market sentiment has dramatically reversed following the Iran war, which triggered the biggest inflation surge since 2023. As reported by Bloomberg, investors are increasingly expecting the Federal Reserve will need to tighten monetary policy this year, prompting several officials to abandon their easing bias. Fed Governor Christopher Waller — a Trump appointee who previously advocated rate cuts — stated last week that the central bank's next move is now just as likely to be a hike. Traders are now pricing in that the Fed is virtually certain to start raising rates by December, representing a complete reversal from before the Iran war when markets had expected two quarter-point rate cuts. However, the outlook has now extended significantly, with markets now pricing in cumulative hikes of roughly 30 basis points through 2027, according to recent market strategist analysis.
While bond markets are betting on rate increases, Fed members and economists largely disagree. According to Reuters reports, Fed funds futures put roughly 50% odds on the U.S. central bank raising rates by December, following a bond-market rout that sent the 30-year Treasury yield above 5%. However, many economists believe the fed-funds market may be overreacting to the surge in oil prices and increase in headline inflation. Will Compernolle, macro strategist at FHN Financial, noted that there's low trading volumes in contracts for the middle of next year, making the market's signals less reliable. The contracts show odds rising through the first half of next year, reaching around 73% by July, but volumes vary widely with the May 2026 contract trading around 646,000 times this month while the January 2027 contract has traded only a third as often.
President Donald Trump has reinforced market expectations by stating on Friday he wanted Kevin Warsh to lead the central bank independently. According to Bloomberg reports, Trump's comments about letting Warsh do his 'own thing' are helping to support the shift toward higher rate expectations. Wall Street also sees borrowing costs going higher, with JPMorgan Chase CEO Jamie Dimon suggesting rates may climb much further. Strategists at major banks including ING Bank, Goldman Sachs, and Barclays indicate the jump in long-term yields may not fully reverse even if inflation driven by higher oil prices eases. Lou Brien, market strategist at DRW Trading, noted that traders are testing how new Federal Reserve Chair Kevin Warsh will respond to rising inflation, which undercuts Trump's desire for lower rates.
Five-year Treasury yields climbed to this year's high of 4.35% last week and were last at 4.26% on Friday, as reported by Bloomberg. 30-year Treasury yields slipped to 5.06%, down from this year's peak of around 5.20%, as oil prices retreated. Benchmark 10-year yields were at 4.56%. The flattening yield curve comes as traders debate whether inflation risks or an economic downturn will ultimately dominate the outlook for the world's biggest bond market. Real yields on 10-year TIPS have climbed to 2.18%, up from 1.91% on May 1st, creating additional pressure on long-duration assets and growth stocks.
