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Recession or Reflation? Bond Options Market Prices in Both Extremes

ByAlfonso Peccatiello
Published 05/05/2025, 22:57
Updated 05/05/2025, 23:26

Bond Market investors are bumping up the odds of a US recession.

Everyone can see the bond market is throwing a tantrum: front-end yields have rapidly declined signaling nervousness about the state of the US economy, yet at the same time long-end yields are not declining as investors require a higher term premium against Trump’s policies.

But the most interesting in bond markets are often observed looking under the hood.

Specifically, the real added value is thinking in probabilities.

The option market allows us to isolate narrow scenarios for bond markets and calculate market-implied probabilities for each.

See the picture below.Option-Implied Probability Distribution for Fed Funds Rate
The right table shows the market-implied probability of Fed Funds being within a specific range at a certain date (March 2026), and the left chart visualizes the probability distribution for Fed Funds in 1 year from now.

What can we notice?

1️⃣ There is still a 12% probability the Fed will end up hiking

Investors are nervous about a recession, yes, but they also acknowledge the inflationary risks coming from tariffs and persistent deficits - hence, a non-trivial 12% probability of Fed hikes is still priced in

2️⃣ The modal outcome is for 4 cuts, once per quarter

The highest bar in the probability distribution (the ’’mode’’ of the distribution) says 4 cuts for a Fed Fund of 3.25% in 1 year from now

3️⃣ Recessionary odds are on the rise!

The market-implied probability that the Fed will deliver cuts in line with a recession (200+ bps in 1 year) has rapidly increased to 22%.

The bond market is well aware of tail risks: inflationary pressures from tariffs and deficits, but also a potential recession looming large.

Which risk do you think deserves the most attention?

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