The non-farm payroll report for May will be released this Friday, with an expected increase of 90,000 jobs. If the data is strong alongside the PCE annual growth reaching 3.8%, the market may price in a more aggressive interest rate hike path.

Written by: Zhao Ying

Source: Wall Street Insights

The bond market is pricing in a shift in Federal Reserve policy, and the non-farm payroll report for May, published this Friday, will be a crucial test for the viability of this bet.

Aside from the situation in the Middle East, employment data has become the largest focus of the market this week. Bloomberg's latest survey indicates that approximately 90,000 jobs are expected to be added in May, with the unemployment rate remaining at 4.3%. If the data confirms the resilience of the labor market, combined with high oil prices and accelerating inflation, the market expects the Federal Reserve to remove the easing bias in its June meeting—marking Chair Kevin Walsh's first policy meeting since taking office.

Traders are currently betting on the Federal Reserve raising interest rates as early as mid-2027, contrasting sharply with prior market expectations that Walsh would quickly move to cut rates after taking over. According to Bloomberg Economics, since the outbreak of the Iran war, the jump in bond yields has effectively tightened financial conditions by about 75 basis points, somewhat replacing the Federal Reserve's rate hike actions.

Yield Volatility at High Levels, Market at a Crossroads

As of now, the benchmark ten-year U.S. Treasury yield is approximately 4.44%, having retreated from the peak levels seen a few weeks ago, partly due to expectations of a ceasefire in the war leading to softening oil prices. Last week’s Treasury auction also demonstrated sufficient demand at the current yield levels.

However, the ten-year yield is still about 50 basis points higher than at the end of February. A recent Treasury options trade in the market has bet on the ten-year yield breaking above 5% within months, a level not seen since 2023.

The two-year yield, which is the most sensitive to interest rate expectations, is currently around 4%, also about 60 basis points higher than at the end of February, nearing the top end of the Federal Reserve's current policy interest rate range of 3.5% to 3.75%, with the spread between short and long yields continuing to narrow.

Inflation Remains High, Rate Hike Expectations Continue to Heat Up

The core logic supporting interest rate hike bets lies in the persistent inflation data exceeding expectations. Last week, data revealed that the Federal Reserve's preferred measure of inflation—the Personal Consumption Expenditures (PCE) price index—rose 3.8% year-on-year in April, far exceeding the 2% long-term target set by officials.

Gregory Faranello, head of U.S. rates trading and strategy at AmeriVet Securities, stated: "If inflation data remains high and job growth remains solid, the market may begin to price in a more aggressive interest rate hike path by the Federal Reserve. Simply hiking rates once will not be sufficient."

More Federal Reserve officials have publicly expressed a desire for the central bank to signal that the likelihood of raises and cuts in future actions is balanced. Cindy Beaulieu, Chief Investment Officer at Conning, which manages approximately $190 billion in assets, pointed out: "Global markets, not just U.S. Treasury yields, are reflecting the same dilemma—how much more inflation can be tolerated and when will it pose a threat to growth."

Increasing Disparities Among Institutions, Short-Term Bonds Favored

Faced with high uncertainty in policy direction, strategies among institutional investors have shown significant divergence, but short-term bonds are generally favored.

George Catrambone, head of fixed income at DWS Americas, noted that rising yields are creating headwinds for the U.S. economy, "doing what the Federal Reserve should be doing." He prefers holding two-year Treasury bonds and purchasing when ten-year yields approach recent highs. He also warned that high inflation eroding real wages will increase pressure on U.S. consumers, ultimately dragging down economic growth.

Loren Moran, a portfolio manager at Wellington Management, previously maintained a "cautious" stance on government bonds due to the potential for a surge in growth and inflation driven by the wave of artificial intelligence capital expenditures. However, as yields soared and rate hike expectations increased, her position shifted, believing that short-term Treasuries "are extremely attractive relative to long-term yields, offering a defensive safe haven."

This week, job vacancy data and ADP private sector employment data will also be released, providing important references for Friday’s non-farm report and further testing the validity of current bets in the bond market.