U.S. bond traders are betting on a Fed rate hike, with May’s nonfarm payrolls set to be a key test.

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The bond market is pricing in a shift in Federal Reserve policy, and the May nonfarm payrolls report released this Friday will be a crucial test for whether this bet can hold.

Aside from the situation in the Middle East, employment data is the biggest focus for markets this week. The latest Bloomberg survey shows that May nonfarm payrolls are expected to increase by about 90,000, with the unemployment rate remaining at 4.3%. If the data confirms the resilience of the labor market, coupled with high oil prices and re-accelerating inflation, the market expects the Federal Reserve to remove its dovish language at the June meeting—the first policy meeting since Chairman Kevin Walsh took office.

Traders are currently betting that the Federal Reserve may raise interest rates as early as mid-2027, which stands in stark contrast to earlier market expectations that Walsh would swiftly cut rates after taking office. According to Bloomberg Economics, since the outbreak of war in Iran, the jump in bond yields has tightened financial conditions by about 75 basis points, to some extent substituting for a Fed rate hike.

Yields volatile at high levels, market at a crossroads

The benchmark ten-year US Treasury yield is currently around 4.44%, down from its peak a few weeks ago, partly because rising expectations of a ceasefire in the war have eased oil prices. Last week's Treasury auction also showed strong demand at current yield levels.

However, the ten-year yield is still about 50 basis points higher than at the end of February. Last week, a Treasury options trade bet that the ten-year yield will break 5% within a few months, a level not seen since 2023.

The two-year yield, which is most sensitive to interest rate expectations, is currently around 4%, also up about 60 basis points since late February, nearing the upper end of the Fed's current policy rate range of 3.5%–3.75%. The spread with long-term yields has continued to narrow.

Inflation remains high, rate hike expectations intensify

The core logic behind rate hike bets lies in persistently higher-than-expected inflation data. Data released last week showed that the Federal Reserve's preferred inflation measure—the Personal Consumption Expenditures (PCE) Price Index—rose 3.8% year-on-year in April, far above the officials' 2% long-term target.

Gregory Faranello, Head of US Rates Trading and Strategy at AmeriVet Securities, said: "If inflation data remains high and job growth stays robust, the market may start pricing in a more aggressive rate hike path for the Fed. Just one hike simply won't be enough."

More and more Fed officials have publicly stated that they hope the central bank signals that the next move for rates could be either up or down. Cindy Beaulieu, Chief Investment Officer of North America at Conning, manages about $190 billion in assets and noted: "Global markets, not just US Treasury yields, are reflecting the same dilemma—how much more inflation can be tolerated, and when will it threaten growth?"

Institutional divergence intensifies, short-term bonds favored

Facing high uncertainty in the policy path, institutional investor strategies have become noticeably more divergent, but short-term bonds are widely favored.

George Catrambone, Head of Fixed Income at DWS Americas, said that rising yields are creating headwinds for the US economy, "doing what the Fed should be doing." He prefers holding two-year Treasuries and buying ten-year bonds when yields approach recent highs. He also warned that high inflation will further erode real wages, increasing pressure on American consumers and ultimately dragging down economic growth.

Loren Moran, Portfolio Manager at Wellington Management, had previously maintained a "cautious" attitude toward government bonds due to the wave of AI capital expenditures possibly accelerating growth and inflation. But as yields have surged and rate hike expectations intensified, her stance has shifted; she believes short-term Treasuries are "extremely attractive relative to long-end yields and provide a defensive safe haven."

This week will also bring job vacancy data and ADP private sector employment data, important leading indicators for Friday's nonfarm payrolls report, and further tests for the strength of current bets in the bond market.

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