Nonfarm payrolls exceeded expectations; rate traders bet the Fed will start raising interest rates in October.

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The U.S. May Non-Farm Payrolls Report far exceeded market expectations, fundamentally changing the landscape of rate market pricing—traders are now fully betting on a Fed rate hike within the year, with the move possibly starting as early as October.

Data released by the Bureau of Labor Statistics on Friday showed May non-farm payrolls increased by 172,000. With upward revisions to the previous two months, the three-month cumulative employment growth was the strongest in over two years. Following the data release, U.S. Treasury bonds experienced a broad sell-off, with yields rising across all maturities. The yield on the two-year Treasury, most sensitive to monetary policy expectations, jumped by 9 basis points in a single day to 4.15%; the 10-year yield rose 6 basis points to 4.53%.

The rates market quickly underwent major repricing. According to Bloomberg, traders have now fully priced in a 25 basis point Fed rate hike before December, assigning about a 60% probability for a hike in October; the SOFR futures yield rose as much as 8 basis points intraday, with the market pricing in a cumulative 41 basis point hike by the end of April next year. In contrast, just a week ago, traders expected the next rate hike would come in March of next year.

Currently, the Fed's benchmark rate range remains at 3.5% to 3.75%, unchanged since last December. The persistent strength in the job market coexists with inflation risks, and this is driving the market’s expectations for the Fed’s policy path to shift rapidly in a tightening direction.

Treasuries Fall Across The Board, Short End Yields Lead the Rise

After the jobs report’s release, the U.S. Treasury market responded rapidly, triggering a broad sell-off. Two-year Treasury yields rose 9 basis points to 4.15% for the day, while the 10-year yield climbed 6 basis points to 4.53%. Short-end rates gained significantly more than long-end rates, reflecting the market’s repricing of near-term tightening expectations for monetary policy.

John Briggs, Head of U.S. Rates Strategy at Natixis North America, said: “Current employment data show an acceleration in the near term, which gives the market a second reason to consider a rate hike, especially as the Strait of Hormuz remains blocked and inflation risks persist.”

Rate Hike Expectations Moved Sharply Forward, Market Pricing Path Reshaped

Before the data release, the widely held market expectation was for the Fed to hike 25 basis points in March next year. After the data, this expectation was completely overturned within just a few hours.

Traders are now pricing in a roughly 24 basis point hike at the Fed’s October meeting, nearly a full rate increase; by the end of April next year, the cumulative hike priced in is 41 basis points, about one and a half hikes. The sharply moved forward hike expectations reflect the market’s simultaneous strengthening assessment of labor market resilience and inflation stickiness.

The market repricing triggered by this employment data further reinforces a growing view: the artificial intelligence boom is driving the neutral rate higher, meaning that the current Fed policy is more accommodative than expected.

If the neutral rate has indeed risen, the actual suppressive effect of the current rate level on the economy is less than the Fed’s own estimates, narrowing the policy space and providing more reason for rate hikes. As long as there are no obvious cracks in the job market and the overall economy remains strong, this logic is gaining wider acceptance in the market.

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