Inflation is the bane of the bond market. And it is now demanding multiple rate hikes, starting late this year.

By Wolf Richter for WOLF STREET.

The 2-year Treasury yield jumped by 12 basis points on Friday, to 4.17%, the highest since February 2025, when it was on the way down. Back then, it was anticipating more rate cuts, which came in the fall that year, three of them.

Now it’s anticipating rate hikes – multiple rate hikes. Yields reflect the summary of the vast bond market’s diverse opinions. Since the end of February, the 2-year yield has jumped by 79 basis points, having switched from expecting a rate cut, to expecting multiple rate hikes. It is now 54 basis points above the Effective Federal Funds Rate, an overnight rate that the Fed targets with its policy rates (blue in the chart).

The trigger on Friday was the jobs report which confirmed that the labor market was fine, with three months in a row of substantial job growth, including upward revisions of the prior two months, and with the three-month average job growth at the highest level since March 2024 (my analysis: Job Growth Turns Around Decidedly after Weakening for Years). This labor market data indicates that the Fed can move inflation to the very top of its worry list.

Both measures of consumer price inflation, the CPI and the Fed-favored PCE price index, will likely show that inflation was over 4% in May, double the Fed’s target, and above the Fed’s target for over five years.

Inflation has been rising for months before the energy shock in March even hit and has metastasized beyond the energy shock to other areas of the economy.

Newly minted Fed chair Warsh is going to have a hard time over the next few months persuading a majority of voting members on the FOMC that a rate cut is needed in this environment, according to the Treasury market; and later this year, he may have a hard persuading a majority that a rate hike is not needed, according to the Treasury market.

The 3-year Treasury yield also jumped by 12 basis points on Friday, to 4.22%, the highest since February 2025, and up by 81 basis points since the end of February. It’s now 59 basis points above the EFFR.

Higher yields mean lower prices – and losses for existing holders. Bonds sold off.

These movements in the yield indicate that the bond market is not only anticipating rate hikes but is also demanding rate hikes because it’s worried about inflation. The bond market can have a powerful voice.

The CPI inflation rate for May may be higher than even the 3-year Treasury yield. Inflation rates have been higher than T-bill yields across the board for a month.

Here we’re looking at a close-up.

The 6-month Treasury yield, which shows bond market expectations of Fed rates over the next 3-5 months, rose to 3.80% on Friday, 18 basis points above the EFFR, a sign that the bond market is expecting the initial rate hike later this year – not next year.

The bond market isn’t just expecting that the Fed will hike rates – it’s putting pressure on the Fed to hike rates.

The Fed will have a major bond-market problem on its hands if inflation continues to be twice its target, or more, and it doesn’t deal with this inflation, and just blows it off, claiming that it would “look through” this inflation for a while. That bond-market problem would manifest itself in the long-term yields – particularly the 10-year and 30-year Treasury yields, and they’re already getting restless.

The 30-year Treasury yield rose above 5% again on Friday, after having been just below 5% for over a week. It has vacillated around the 5% line, a little above, a little below since early April. On May 19, it had hit 5.19%.

My imaginary trend line connects some of the lows along the trend of higher lows. The yield-yo-yo has been narrowing for a year as the bond market has been getting more convinced about the direction this is going: There is trouble brewing in the bond market.

Trouble in the bond market is twofold: A recognition that higher inflation, perhaps in the 3-4% range or may higher will be tolerated, if not desired, which means that yields need to rise to remain sufficiently above it. And a fear that the path of the Treasury debt, its growth of over $2 trillion a year, is not “sustainable” – that eventually something has to give, namely whatever might be left of price stability.

The 10-year Treasury yield jumped by 8 basis points to 4.55% at the close on Friday.  At this level, the 10-year yield is not high for this inflationary environment — and might be low:

The bond market is still, if half-heartedly, buying the story that long-term inflation will go back toward 2.5% or so, and a 10-year yield in the current range would be about appropriate for that kind of average inflation rate.

But to get an average inflation rate of 2.5% over 10 years while inflation is allowed to go over 4% is going to be tough. And the 10-year yield remains very unattractive at this level, given that the Fed and the government apparently agree on letting the economy “run hot,” with more nominal economic growth, faster wage growth, and higher inflation rates, in order to deal with the huge and growing national debt before it spirals into fiscal chaos.

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