Bond markets are pricing in a shift in Federal Reserve policy, with the May non-farm payrolls report due this Friday set to be a key test of whether this bet can hold. Beyond the Middle East situation, employment data has become the primary market focus this week.

A Bloomberg survey indicates expectations for May non-farm payrolls to increase by approximately 90,000, with the unemployment rate holding steady at 4.3%. If the data confirms labor market resilience, coupled with elevated oil prices and re-accelerating inflation, markets anticipate the Fed will remove its accommodative bias at the June meeting—the first policy meeting under new Chairman Kevin Wash.

Traders are currently betting on the Fed raising rates as early as mid-2027, a stark contrast to previous market expectations for rate cuts soon after Wash's appointment. According to Bloomberg Economics, the surge in bond yields since the outbreak of the Iran war has tightened financial conditions by an equivalent of about 75 basis points, partially substituting for Fed rate hikes.

The benchmark 10-year Treasury yield is currently around 4.44%, down from recent peaks partly due to expectations for a ceasefire easing oil prices, and last week's Treasury auctions showed sufficient demand at current yield levels. However, the 10-year yield remains about 50 basis points higher than at the end of February.

A Treasury options trade last week bet the 10-year yield would break above 5% within months, a level not seen since 2023. The more rate-sensitive 2-year yield is around 4%, also about 60 basis points higher than late February, nearing the upper bound of the Fed's current 3.5%-3.75% policy rate range, with its spread to longer-term yields continuing to narrow.

The core logic supporting rate hike bets is persistently higher-than-expected inflation data. Recent figures showed the Fed's preferred inflation gauge, the Personal Consumption Expenditures (PCE) price index, rose 3.8% year-over-year in April, well above officials' 2% long-term target.

Gregory Faranello, Head of US Rates Trading and Strategy at AmeriVet Securities, stated: "If inflation data remains high and job growth stays solid, markets may start pricing in a more aggressive Fed hiking path. A single hike would be largely ineffective."

A growing number of Fed officials have publicly expressed a desire for the central bank to signal that the next move is as likely to be a hike as a cut. Cindy Beaulieu, Chief Investment Officer for North America at Conning, which manages about $190 billion, noted: "Global markets, not just US Treasury yields, are reflecting the same dilemma—how much more inflation can be tolerated, and when it becomes a threat to growth."

Facing high policy path uncertainty, institutional investor strategies show significant divergence, but short-dated bonds are generally favored. George Catrambone, Head of Fixed Income for the Americas at DWS, said rising yields are creating headwinds for the US economy, "doing what the Fed should be doing." He favors holding 2-year Treasuries and buying 10-year notes when yields approach recent highs. He also warned that high inflation eroding real wages will increase pressure on US consumers, ultimately dragging on growth.

Loren Moran, a portfolio manager at Wellington Management, previously maintained a "cautious" stance on government bonds due to potential growth and inflation acceleration from AI capital expenditure. However, with yields surging and rate hike expectations rising, her view has shifted, seeing short-term Treasuries as "extremely attractive relative to the long end, offering a defensive haven."

This week will also see the release of job openings data and ADP private payrolls, which will provide important leading indicators for Friday's non-farm report and further test the validity of current bond market bets.