As U.S. inflation rises, several economists reassure: the bond market may have "overreacted."

Impacted by resurgent inflation, the U.S. bond market has recently continued to rise, pushing the probability of a Fed rate hike this year to about 50% in the federal funds futures market. However, most economists disagree, believing the market is overreacting.

According to Reuters, analysts point out that the relevant futures contracts have seen thin trading volumes recently, making their pricing credibility limited. This means that the roughly 50% rate hike probability shown by the market may not truly reflect rate hike expectations, but is more likely a price distortion caused by insufficient liquidity. In fact, although bond yields have risen sharply—30-year U.S. Treasury yields broke 5%, 10-year yields reached a 15-month high, and the 2-year hit a stage high—futures markets have not formed a clear rate hike bet. Contracts show the probability of the Fed raising rates as early as December is only about 50%, not rising to about 73% until July next year.

Meanwhile, Fed officials have yet to issue any clear signals of rate hikes. At the April policy meeting, the Fed kept rates unchanged at the 3.50%–3.75% range, with only one member voting to cut rates by 25 basis points, and no one openly implying a rate hike is imminent.

The U.S. economy is currently facing a dilemma: inflation remains persistently above the Fed's 2% target and is trending away from it, while the labor market has not significantly deteriorated, leaving policymakers in a bind. In addition, the policy stance of new Fed Chair Kevin Warsh remains to be tested by the market, further heightening uncertainty.

Doubts on Futures Market Signals, Thin Trading Volumes Are Key

Many analysts hold a reserved attitude toward the rate hike signals conveyed by the futures market, with the main reason being the extremely limited trading volumes of distant contracts.

Will Compernolle, macro strategist at FHN Financial, pointed out that trading volumes for contracts maturing in mid-next-year are quite low. Data shows the May 2026 contract traded about 646,000 times this month, while the January 2027 contract's volume is only one-third of that, and the July 2026 contract traded only about 6,400 times. He stated, "This is a low-confidence signal from the market; it may just be hedging against the risk of a rate hike."

Ryan Swift, chief U.S. bond strategist at BCA Research, similarly believes the market's response speed has exceeded what the data can support. "Financial markets absorb new information far faster than data can evolve," he said. "Sometimes the market can capture the correct signal ahead of economists, but more often, it’s just overreaction."

Dual Mandate Is a Constraint, Rate-Cut Window Remains Shut

The Fed’s current policy dilemma comes from the obvious tension between its dual mandate of full employment and low inflation.

On inflation, overall inflation remains far above the 2% policy target, and recent oil price increases have further pushed up inflationary pressure. On employment, the labor market has not seen substantial deterioration sufficient to justify a rate cut. John Luke Tyner, portfolio manager at Aptus Capital Advisors, stated: "The Fed now can’t use labor market weakness as a reason to support rate cuts like it did last year."

Notably, at the April policy meeting, three members of the monetary policy committee raised objections to the statement suggesting the Fed would eventually resume rate cuts, a detail showing growing internal disagreement on the future policy path.

Warsh’s Stance under Test, Market Gauges the New Chair’s Bottom Line

Recent bond market volatility is also closely related to the market testing the policy stance of new Fed Chair Kevin Warsh in response to rising inflation.

Lou Brien, market strategist at DRW Trading, believes that the market is watching to see if Warsh can maintain independence from Trump’s desire to lower rates. “Especially as oil prices remain high, the market wants to see Warsh act independently rather than as the President’s spokesperson at the Fed,” Brien said.

Warsh served as a Fed Governor from 2006 to 2011 and was known for his hawkish stance. He previously stated there was room for rate cuts at the Fed, but has not commented publicly since the April economic data release, leaving his actual policy inclination still to be clarified.

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