The US Treasury market is bracing for its most significant macroeconomic test in recent times. As the Federal Reserve's upcoming policy meeting approaches, market expectations have pivoted sharply from anticipating rate cuts at the start of the year to now pricing in hikes over the next year. However, on the eve of the release of Friday's May non-farm payrolls report, this highly uniform market consensus faces a potential shake-up. If job growth shows a marked slowdown, Treasury yields could plummet rapidly, potentially triggering a painful short squeeze for traders who have been consistently betting on rising rates over recent months.
From Two Cuts to One Hike: A Complete Market Reversal
At the beginning of the year, the US interest rate market widely expected the Federal Reserve to implement two rate cuts within the year. However, since the escalation of Middle East tensions and the outbreak of US-Iran military conflict in late February, a surge in global energy prices and a resurgence in US inflation prompted a swift market correction. Latest data shows US inflation remains around 3.8%, significantly above the Fed's long-term 2% target, with core PCE growth still over 3%. Concurrently, the US economy has demonstrated notable resilience. April's non-farm payrolls increased by 115,000, exceeding prior market forecasts, and the unemployment rate has held steady at 4.3% for several months. Several Fed officials, including the Dallas Fed President, have recently suggested that further policy tightening remains possible if inflation persists.
In this context, the interest rate swap market now prices in: the disappearance of 2026 rate cut expectations; a nearly 70% probability of a hike by the end of 2026; and a 25-basis-point hike by March 2027 as the prevailing market consensus.
Oil Retreat Shifts Focus Back to Jobs
The key driver behind the升温的加息预期—energy prices—has recently shown significant change. As expectations for stabilizing Middle East conditions grow, international oil prices have retreated noticeably from their conflict peaks. The US 2-year Treasury yield has fallen from its high a month ago, and the 10-year yield has also retreated to around 4.47% from its peak near 5.19% earlier this year. This signals a shift in market focus from inflation back to the labor market.
Economists generally forecast for May: non-farm payroll growth around 80,000 to 85,000; unemployment holding at 4.3%; and a slowdown in year-over-year average hourly earnings growth. If the data meets or falls below these expectations, the market will begin reassessing whether the Fed truly needs to maintain its hawkish stance.
Bryce Doty, a bond fund manager, stated, "If the data is strong, yields might only rise slightly; but if employment is weak, the downside for yields could be far greater than the upside." He believes short positions in US Treasuries have become excessively concentrated.
SOFR Options Market Shows Signs of Retreat
This caution is already evident in the interest rate derivatives market. This week saw large-scale unwinding and position adjustments in the SOFR (Secured Overnight Financing Rate) options market. SOFR is a key policy expectation indicator in the US rate market, and its options trading is often viewed as a gauge of institutional investors' outlook on future monetary policy.
Trading data indicates some large institutions are reducing extreme hawkish bets and using options to hedge against potential volatility from the jobs data. A major bank's rates strategy team recently advised investors to "tactically take profits on 2-year Treasury longs." However, the team also noted the current market risk structure is highly asymmetric: stronger-than-expected data could lead to further bond selling, but weaker-than-expected data might trigger a more substantial rebound. This suggests growing concern that "rate hike trades" have become too crowded.
Subtle Shifts Emerging in US Labor Market
Despite a stable unemployment rate, increasing signs suggest the labor market may not be as robust as it appears. Recently released data shows: May ADP private payrolls rose by 122,000, exceeding expectations; JOLTS job openings rebounded to a two-year high; but corporate layoffs approached 97,000, among the highest levels since the pandemic.
Some analysts argue the US job market is entering a new equilibrium with slower hiring but also limited layoff规模. Analysis suggests the US labor market may be concluding a multi-year phase of "low hiring, low firing" and entering a channel of moderate recovery. However, other views hold that employment data may understate actual pressure. Some market researchers point to indicators like persistently declining temporary help employment and a low labor force participation rate as signs of underlying weakness in the job market's structure.
First Policy Meeting Under New Leadership Nears
The market faces another significant variable—new Federal Reserve Chair. The upcoming FOMC meeting on June 16-17 will be the first policy meeting chaired by the new appointee. The market currently assigns the highest probability to the committee maintaining the rate at 3.50%-3.75%. However, new economic projections and the interest rate dot plot will be a key market focus.
The International Monetary Fund warned this week that energy shocks and tariff pass-through effects could still push future inflation higher, advising the Fed to remain cautious. The IMF forecasts the timeline for US inflation to return to 2% could be delayed until late 2027.
Market Watch: The Real Risk Lies in Consensus Trading
From a market structure perspective, the greatest risk may not be the jobs data itself, but the highly uniform consensus that has formed. Over the past three months: fund managers have persistently reduced duration; the interest rate swap market has bet on hikes; short positions in US Treasuries have accumulated; and most Wall Street firms have rescinded their rate cut forecasts for 2026. With the exception of one major bank, most large investment banks have abandoned expectations for 2026 rate cuts.
However, if the non-farm payrolls data shows significant weakness, the market will be forced to re-examine three questions: Is the US economy beginning to lose growth momentum? Is the current 3.8% inflation merely a temporary energy shock? Will the Fed under its new leadership be more inclined to wait than the market expects?
For the bond market, true danger often lies not in unexpected events, but when everyone is positioned in the same direction. Friday's non-farm payrolls report could well become the first domino determining the direction of global interest rate markets for the second half of the year.
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