Monthly Economic & Interest Rate Outlook (MEIRO) – The Fed stuck in a Strait jacket

Executive summary

Key updates: We’ve increased our inflation outlook for 2026 due to elevated crude oil prices, punted one Fed rate cut into 2027, and bumped up our view on U.S. Treasury yields.

Economic environment:

• As this month’s headline implies, the prolonged stalemate in the Strait of Hormuz is confining global economies, particularly in Asia, along with policy options.
• While the Iran conflict complicates the economic narrative on multiple fronts, it’s not game over for the U.S. economy in terms of a recession. That said, it widens the range of potential outcomes, including the timing and pace of future Fed rate cuts.

Federal Reserve (Fed) outlook:

• The Fed’s leadership transition—beginning the Warsh era—is likely the only change in the near term, though Fed personnel distractions will likely persist through the summer.
• The Fed remains on hold for now, taking a wait-and-see stance towards the crude oil-induced inflation. While we believe the Fed’s end point remains the same near 3% by the end of 2027, the timing of rate cuts is complicated by the Iran situation.

Impact on yields:

• Traders are positioning for a Fed on hold, with a bias toward one rate hike before year end. The 2-year U.S. Treasury yield is roughly 60 basis points (0.60%) above pre-conflict levels. Short-dated rates should decline if a durable resolution emerges, which would ease concerns around persistent inflation.
• The stalemate in U.S.-Iran peace talks reversed previous declines in longer-term (>3 years) yields back to 10-month highs. A durable resolution in the Middle East should encourage lower yields, but fiscal and trade policy concerns will keep them relatively sticky, leading to a resumption in the U.S. yield curve steepening.

Key factors shaping our outlook

Federal Reserve – Warsh era begins, but don’t expect quick changes

• Kevin Warsh was confirmed as the 17^th Fed Chair.
  • Fed personnel distractions will likely persist through the summer and beyond, driven by Stephen Miran’s exit, Lisa Cook’s unresolved Supreme Court case, and Jerome Powell’s decision to remain on the Board after his term as Chair ends.
  • While there will be changes, we anticipate more gradual shifts and pivots under Chair Warsh rather than a massive wholesale overhaul. Our view is informed by the consent required for the larger moves by the broader Fed Board and the rate setting Federal Open Market Committee. Moreover, while Warsh will undoubtedly alter communication, we expect much of the changes will be stylistic, including tone and cadence.
  • In the near term, Warsh will be shackled by the same challenges as Powell—stickier inflation, inconsistent job growth, and supply chain constraints due to the Iran War. While the Fed Chair matters, many other factors are collectively MORE important to economic growth, such as interest rates, productivity and AI investment, global growth, fiscal policy, and geopolitics.
• While we believe the Fed still aims to lower the federal funds rate towards 3%, the recent inflationary pressures will delay additional rate cuts. We now see just one rate cut in 2026.

U.S. Macro – Tech spending has taken the growth baton

• The U.S. economy continues to power through the uncertainty caused by the Iran War and the subsequent spike in gasoline prices. Important drivers – such as AI-led tech investment – have taken the baton as a key growth engine.
• The Iran-induced crude oil spike fueled the inflation surge in April, too. The push higher in inflation – replete with continued pain at the pump and the sour consumer vibe – will linger for months.
  • From a price and global supply perspective, the damage is already done to the global economy by crude oil due to the Strait of Hormuz being effectively closed.  
  • Inflation and interest rates remain elevated globally, while simultaneously diverting spending toward energy from other categories, and uncertainty is mounting. While the U.S. is largely insulated from an energy supply shock since more than 90% of our supply is sourced within North America, prices are set globally, which is being impacted by the effective shutdown of the Strait of Hormuz. Still, the determining factor for the U.S. economic drag will be the duration of the conflict and crude oil prices.
• Uncertainty remains another downside risk – for trade and supply chains, for Fed policy, etc. That widens the range of potential economic outcomes.
• Three positive drivers remain intact – tax incentives for consumers and businesses, contained tariffs, and continued investment in AI and technology spending. On the first point, personal federal tax refunds ended up 18.3% above last year. Those are a very real boost to consumers, along with a substantially reduced bill for high-income taxpayers. On the second point, the effective U.S. tariff rate has dropped to 11.1% from roughly 15% six months ago. Also, the federal government is expected to refund about $170 billion in tariff overpayments to roughly 330,000 importers starting in late April 2026. On the capex front, U.S. utilities expect to spend $1.1 trillion in next five years.
• Employment trends remain critical. It appears that the jobs growth trend has improved, including the first back-to-back monthly gains in a year during March and April, along with the upshifts in the six-month averages for overall job growth and private payrolls. We anticipate that headline payrolls will average 65K per month and unemployment will tick higher by the end of 2026 to 4.5%.
• Reshoring will continue to support growth, but don’t expect big job growth within manufacturing. Most of the new plants being built in the U.S. are heavily automated and mechanized. Indeed, there will initially be construction-related work, along with ongoing logistics jobs, but reshoring won’t meaningfully boost hiring within manufacturing.

U.S. interest rates

• Base case scenario: We believe that peak tensions between the U.S. and Iran are behind us. Against that backdrop, U.S. Treasury yields should fall (i.e., prices rise) from current levels across the curve with the assumptions that persistent inflation worries ease and the Fed debates easing later this year. If improved shipping traffic through the Strait of Hormuz is achieved in the coming weeks, markets should be more willing to dismiss hotter inflation data as temporary and manageable, which should help the yield on the 10-year fall towards 4.25%.
  • In this scenario, yield declines are likely to be more pronounced in shorter-dated maturities, which are more sensitive to Fed rate policy. If the Fed can resume a gradual normalization of monetary policy later this year, longer-dated yields should be spurred somewhat lower, too. However, U.S. fiscal imbalances, resilient economic growth, and robust government debt issuance may constrain their decline. Thus, the net result should be a return to steepening in the yield curve as longer-dated yields prove a bit “stickier.”
• A less favorable scenario would be if the conflict reignites and the Strait of Hormuz remains shuttered. That would include inflation outlooks being revised higher, increased U.S. military spending, worsen budget deficits, and the potential for more government debt issuance. This would probably push yields beyond 3-year maturities higher, particularly in the longest portion of the yield curve.
  • However, we suspect the 10-year U.S. Treasury yield would find it difficult to sustainably breach the 4.5% threshold for two primary reasons. First, a prolonged conflict would fuel greater global growth concerns, which tend to apply downward yield pressure. Second, the equity market has shown discomfort in recent years when the 10-year yield has flirted with 4.5%, powering a flight-to-quality into U.S. Treasuries.
  • In shorter-dated maturities, we would expect yields to move only slightly higher from current levels. Traders have positioned for the Fed to remain on hold for the entirety of 2026, and we believe the bar for a Fed rate hike is very high.
• Borrowing costs: The recent rise in U.S. Treasury yields pushed up borrowing costs, retracing a portion of the declines since the U.S-Iran ceasefire began. While we expect borrowing costs to fall modestly over the next year, we don’t anticipate a dramatic decline in rates nor a big catalyst for growth. For instance, 30-year fixed mortgage rates should drift modestly lower, but home prices are a much larger challenge for housing affordability than mortgage rates.
• U.S. credit spreads remain tight based on optimism around the fragile ceasefire but are still above the extreme tights touched in January. Current spreads still signal the market’s confidence in the U.S. economy and its companies. As credit spreads approached their widest levels in almost a year, we upgraded our outlook for the high yield corporate bond sector from less attractive to neutral. Although they have meaningfully tightened, absolute yields are supportive of a constructive total return outlook.

Global and geopolitical

• The Strait of Hormuz remains blocked by both the U.S. and Iran, leading to energy shortages in Asia that are beginning to impact the economic outlooks in other regions. The Middle East's output of helium, aluminum, naphtha, and other essential petrochemicals is creating considerable risks for Asian manufacturers.     
• Higher energy prices have caused global inflation to surge. For the first time since the Covid years, average inflation in G7 countries has surpassed policy rates, restricting central banks from reducing rates any further. 
• In the United Kingdom, there has been a shift in political sentiment, with Prime Minister Keir Starmer encountering dissent within his own party. Borrowing costs have increased to levels not observed since the 1990s, and the British pound has begun to depreciate versus the U.S. dollar.
• For the U.S. dollar, we expect a wider, volatile range with a near-term upside bias. While concerns about the Fed's stated easing bias and large federal budget deficits could pressure the dollar, robust U.S. growth and higher yields can offset this.
• There are four key elections in 2026 – the critical U.S. midterms, general elections in Brazil including the presidency, India’s local elections in five states that play a pivotal strategic role for the national parties, and a presidential election in Colombia.  

Risks to our outlook

• An expanded or protracted Iran conflict, particularly regarding the Strait of Hormuz. This could result in sustainably higher inflation by disrupting the global oil supply chain, tariffs, and other factors. That would hinder declines in U.S. interest rates and hamper growth.
• Continued trade uncertainty or new flare-ups, which would ratchet up uncertainty. 
• While companies had largely been in “low hire/low fire” mode during 2025, a dramatic deterioration in the labor market would slow economic momentum. 
• Global bond market participants initiate a “buyer’s strike” against government-issued debt in response to ongoing fiscal largesse and robust debt issuance, thereby forcing U.S. and international yields (i.e., government borrowing costs) higher.
• Additional government dysfunction and the potential for policy gridlock to impede important legislation, such as federal budgets, the debt ceiling, and key confirmations. Democratic gains in the midterm elections could upend the current Republican mandate. 
• Slower/sluggish global growth, primarily in China, Europe and the United Kingdom.
• Political tensions abroad causing reduced demand for U.S. goods or travel to the U.S., with some countries actively avoiding American products.