I don’t know about your specific scale, but the way these scales work, what they are measuring is how well your body transmits electricity. The more water, the better it transmits.
Muscle has more water than fat does, so if you lose fat, the percentage of water in your body will increase.
But I have no idea what your particular scale is reporting on.
You already answered your own question in your opening statement.
I’ll add a bit of context.
The way these scales work is that body conductivity tests are done on a broad range of people where they use a dunk tank to measure their body composition accurately. Different body fat percentages, muscle mass, etc and then correlated to conductivity readings. Those are programmed into the scale. The thing is that if the vendor publishes any accuracy specifications, they are always around plus or minus 20% on any reading. That’s a huge range. You cannot rely upon precise readings from these scales.
In addition, what happens when you start cutting weight and adding exercise is kind of complex. You can lose muscle mass despite exercising during weight loss, but you also can gain strength and improve quality of muscle at the same time. I really like this NIH published paper on the topic. Your real muscle mass doesn’t move the way you think it would because muscle mass and strength don’t always track.