2026 Outlook: Treasury Bonds and Fixed Income

It's been a bumpy ride in the bond markets so far this year, and that trend may continue in the second half of the year. Inflation remains sticky, the Federal Reserve appears likely to stay patient, and we believe the 10-year Treasury yield may hold in the 4% to 4.5% range it has mostly held since early March, although there are risks to the upside. But keep in mind that past performance is no guarantee of future results. Geopolitical risks, especially in the Middle East, have also become more important for bond investors because of their potential impact on oil prices, inflation, and Fed policy.

Our broad message for the second half of 2026 is this: Income still matters, but investors should be selective. Despite the recent rise in Treasury yields, we suggest investors favor a below-benchmark average duration with their bond holdings, favoring short- and intermediate-term maturities. In our view, now is not the time to favor long-duration investments just yet.

Our more favorable areas of the fixed income market today include investment grade corporate bonds, high-yield bonds, and preferred securities. Each comes with risks, like the risk that prices fall relative to Treasuries if the economic outlook deteriorates, but we believe that all three offer compelling income opportunities in a market where Treasury yields may stay relatively elevated.

The Fed now appears to be in wait-and-see mode. Our base case is that the Fed remains on an extended pause for now, holding its benchmark interest rate steady through the end of the year. With the labor market having stabilized lately, the Fed will be paying attention to inflation for guidance on its next move, whether that's a hike or a cut down the road.

Most inflation indicators have been above the Fed's 2% target for five years and counting, and they are now moving in the wrong direction. With inflation expected to remain elevated, rate cuts do not seem likely anytime soon. Price stability is one of the Fed's dual mandates, so the fight against inflation is not yet done. Rate cuts when inflation remains elevated could pull it even higher if it spurs more spending.

That does not mean that the next move will necessarily be a hike, however. The risk of a rate hike has risen lately, but it is not our base case. The risks are two-sided—the next move by the Fed, whenever it comes, could be a hike or a cut.

The chart below highlights how much the outlook has changed since earlier this year. At the end of February, the Fed funds futures market was pricing in nearly three cuts by June 2027. Market expectations now point to a hike, but the implied probability has been fluctuating given so much uncertainty around the conflict in the Middle East and how various Fed officials have reacted to the recent increase in inflation in their recent speeches and interviews.

Here are some factors that the Fed would likely consider before raising rates:

• If core inflation continues to move higher. The core personal consumption  expenditures (PCE) index rose by 3.3% year over year in April, its highest reading since November 2023.
• Whether inflation expectations become unanchored. Rising inflation expectations can make inflation a self-fulfilling prophecy if it pulls forward consumer spending. So far, intermediate- and long-term inflation expectations remain somewhat anchored, although they've increased a bit over the last few months.
• If the labor market strengthens. Lately it's been "stable" rather than "strong," and the Fed might want to see a stronger labor market to handle tighter policy.

In other words, the Fed likely needs a clear reason to hike. Sticky inflation alone may keep the Fed on hold, but a more meaningful and sustained rise in inflation, or inflation expectations, would likely be needed to push policymakers toward a more hawkish stance.

The Middle East is an important risk to this outlook. A prolonged conflict could keep oil prices elevated, which would likely put upward pressure on inflation. Higher energy prices can work their way through the economy in a number of ways, from higher gasoline prices to transportation costs to broader input costs for businesses. If those pressures persist, the Fed may worry that inflation will take longer to return to its target. In that scenario, the risks would tilt more toward a rate hike.

On the other hand, a de-escalation in the Middle East could reduce that pressure. If tensions ease and oil prices fall, inflation concerns could moderate and the probability of a Fed hike would likely decline. That is one reason investors should pay attention not only to traditional economic data, such as inflation and jobs reports, but also to geopolitical developments and oil prices.

For investors, this outlook likely means short-term rates may remain stable.

We believe the 10-year Treasury yield will remain mostly in a 4% to 4.5% range over the near term. We see more risks to the upside than the downside, as there are a number of factors discussed below that should put upward pressure on yields. While a rising risk of recession is a key factor that could pull yields lower, that's not our base case.

The same factors that we expected to keep long-term Treasury yields elevated coming into the year are still present: sticky inflation, fiscal concerns, rising global bond yields, and the term premium. With inflation elevated, we think investors may continue to demand higher yields to compensate for the risk that it might not move lower anytime soon. Inflation can pose a meaningful risk to bond investors because even though the coupon rates are often fixed, rising inflation can eat away at the value of those coupon payments.

Oil prices are also part of the story. Treasury yields and oil prices have recently moved in the same general direction because oil has become a key signal for inflation risk. When oil prices rise, investors may worry that inflation will stay higher for longer, which can push Treasury yields up.

Another factor that could keep long-term yields elevated is the term premium. Put simply, the term premium is the extra yield investors demand to own a longer-term bond instead of a series of short-term bonds. For many years following the global financial crisis, the term premium was very low, likely driven by relatively low and stable inflation as well as the Fed's large bond-buying programs. Today, the environment looks different. Inflation uncertainty has risen, and the Fed is unlikely to use its balance sheet as aggressively as it did in the past. The term premium has risen from March 2020 lows but is still below the long-term average and well short of previous peaks. That could mean that the term premium continues to rise as investors require more compensation to hold long-term bonds, keeping long-term Treasury yields "higher for longer."

For the 10-year Treasury yield to fall back below 4%, we think the economic backdrop would likely need to deteriorate with a rising risk of recession. In that environment, investors would likely seek the safety of Treasury bonds, and markets might begin to price in a greater chance that the Fed eventually cuts rates. That's not our base case, however.

Given this outlook, we favor a below-benchmark average duration.¹ Since we believe the 10-year  Treasury yield may stay in that 4% to 4.5% range and the risks are tilted somewhat to the upside, we do not think now is the time to aggressively add duration. If Treasury yields continue to move higher, there may be an opportunity for investors to consider more longer-term bonds, but we're not there yet.

That said, we also don't think investors should focus only on very short-term investments. Those investments can play a role in a portfolio, especially for liquidity needs, but it might mean investors sacrifice yield today. The yield curve is currently positively sloped, meaning investors can generally earn more income by moving somewhat further out in maturity. The largest yield increases since the end of February have been with yields in the two- to five-year part of the yield curve. Staying too short may come with an opportunity cost.

We see opportunities for investors to consider adding risk in moderation with investment grade corporate bonds, high-yield corporate bonds, and preferred securities.