By Karen Brettell
NEW YORK, May 19 (Reuters) - It looks like the bond market is betting a Federal Reserve rate increase could be on the way -- but Fed members and economists mostly don't seem to think so. What's going on?
Fed funds futures - the market's favorite tool for predicting rate moves - put roughly 50% odds on the U.S. central bank raising rates by December, following a bond-market rout that sent the 30-year Treasury yield above 5%, the benchmark 10-year yield to a 15-month high and the two-year
yield to the highest since March 2025.
But many economists believe the fed-funds market may be overreacting to the surge in oil prices and the increase in headline inflation, at a time when Fed members have refrained from suggesting rate hikes are in the offing soon. Some analysts caution that the market's signals may be less reliable than they appear because there is less trading in contracts that expire months down the road.
"There's really low trading volumes in the contracts for the middle of next year," said Will Compernolle, macro strategist at FHN Financial. "I consider it a pretty low conviction signal from the market. The market might just be really hedging for the risk that a hike does eventually come."
The contracts show the odds of a rate increase rising through the first half of next year, reaching around 73% by July.
But volumes vary widely and tend to decline over time. While the May 2026 contract has traded around 646,000 times this month, for example, the January 2027 contract has traded just a third as often and the July contract next year has changed hands only 6,400 times.
INFLATION CONCERNS
Ryan Swift, chief U.S. bond strategist at BCA Research, thinks the market is moving faster than the data justifies. "The financial markets move very quickly to incorporate new information faster than the actual data," he said. "Sometimes the market's picking up something right, and economists will eventually follow. But often, it's just overreacting."
The Fed held interest rates steady in a range of 3.50% to 3.75% at its April meeting, with just one dissent in favor of a quarter-point rate cut. Notably, three members of the monetary policy committee objected to language in the statement suggesting the Fed would eventually resume cutting rates.
The Fed's dual mandate of full employment and low inflation puts the central bank in a bind. Inflation remains well above the Fed's 2% target and is moving in the wrong direction, yet there has been no serious deterioration in the labor market that would give policymakers cover to lower rates.
"The Fed can't really point to that like they could last year when we got a couple of cuts," said John Luke Tyner, portfolio manager at Aptus Capital Advisors.
Some of the recent bond-market volatility is also likely tied to traders testing how new Federal Reserve Chair Kevin Warsh will respond to rising inflation, which undercuts Trump's desire for lower rates, said Lou Brien, market strategist at DRW Trading.
"Especially if the crude oil stays high, they're going to want to see that Warsh is his own man rather than the president's man at the Fed," Brien said.
Warsh served on the Fed's board from 2006 to 2011 and developed a reputation as an inflation hawk during that time. He has said there is room for the central bank to lower interest rates but has not commented publicly since April's data was released.
(Reporting by Karen Brettell, editing by Colin Barr and David Gaffen)
