Executive summary
Key updates: The sharp pullback in crude oil cooled inflation in June. That should help ease the pressure on both consumers and the Federal Reserve (Fed)
Economic environment:
- The U.S. economy appears to be gathering momentum with recent improvement in the job market and manufacturing surveys. Now, inflation is receding, which is reducing some urgency around a Fed response.
- Recent inflation moderation and steady economic activity are encouraging; however, one month doesn’t make a trend. The 15% jump in crude oil prices this past week underscores the risk that inflation progress could stall or reverse. While June's data were encouraging and suggest inflation may have peaked in May, more follow-through is needed to confirm a sustained disinflation trend.
Federal Reserve (Fed) outlook:
- The Fed remains on hold for now, taking a wait-and-see stance towards oil-induced inflation and recent labor market resilience. The welcomed cooling in consumer and wholesale inflation data in June should reduce the urgency that some Fed policymakers are feeling to tighten monetary policy. We still believe the bar for a rate hike remains high.
Impact on yields:
- Traders are currently positioning for the Fed to execute one 0.25% rate hike before year-end. The 2-year U.S. Treasury yield is roughly 80 basis points (0.80%) above pre-conflict levels. We expect short-dated rates to decline if a durable resolution emerges in the Middle East, but a stable ceasefire remains evasive.
- The unresolved U.S.-Iran peace talks are keeping longer-term (>3 years) yields elevated and choppy. A peace agreement in the Middle East should encourage lower yields, but fiscal and trade policy concerns will keep them relatively sticky, leading to a resumption of U.S. yield curve steepening.
Key factors shaping our outlook
U.S. Macro – Starting to gather momentum
- 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 conflict remains a massive overhang on many fronts; most prominently, the direction of crude oil prices and related inflation. A prolonged disruption around the Strait of Hormuz is a risk.
- Inflation recoil – Crude oil prices have retreated from more than $110 in April to the $70-range as supply increased and demand softened. Higher output from OPEC+, the U.S., and Canada, expanded pipeline flows, and the release of stranded tankers boosted supply, while China cut crude imports by an estimated 3–4 million barrels per day.
- Moderating inflation and steady growth support the view that the bar remains high for a Fed rate hike this year. Still, one month doesn’t make a trend, and the roughly 15% jump in crude oil prices this past week underscores the risk that inflation progress could stall or reverse. While June's data were encouraging and suggest inflation may have peaked in May, more follow-through is needed to confirm a sustained disinflation trend.
- Similarly, interest rates remain elevated globally, which restricts growth. Elevated gasoline prices are diverting spending toward energy from other categories, and uncertainty persists.
- 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.
- Employment trends remain critical. The jobs growth trend has improved, averaging 92,000 per month over the past six months (up from 27,000 a year ago), while the unemployment rate dipped to 4.2%.
- 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 & Federal Reserve
- We maintain our view that the Fed remains on hold for now, taking a wait-and-see stance towards oil-induced inflation and recent labor market resilience. Inflation expectations remain anchored and recent cooling in a handful of inflation data points reduce the likelihood that the Fed will need to tighten policy soon.
- Fed changes: Chairman Warsh announced a five-pronged review of key areas – including Fed communications – that should be completed by year-end. We anticipate gradual shifts – rather than a massive wholesale overhaul – with mostly stylistic changes, including tone and cadence.
- 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 avoids increasing its policy rate. If shipping traffic through the Strait of Hormuz improves in the coming weeks, markets should grow more confident that inflationary pressures will further subside. That would likely 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 currently positioned for a higher Fed funds rate. If the Fed ultimately avoids a rate hike, 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, worsened 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 (as evidenced at the beginning of July) 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, having already moved higher on recent inflationary concerns. Traders have positioned for the Fed to hike rates one time (0.25%), but we believe the bar for a Fed rate hike is very high.
- Borrowing costs: On balance, short- and intermediate-term lending rates rose in sympathy with U.S. Treasury yields over the past month. While we expect borrowing costs to fall modestly over the next year-and-a-half, 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 but slightly above the extreme tights touched in January. Current spreads still signal the market’s confidence in the U.S. economy and its companies. In March, 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 tightened meaningfully, absolute yields are supportive of constructive total return outlooks for investment grade and high yield corporate bonds.
Global and geopolitical
- The Iran conflict remains unresolved with an abrupt end to the ceasefire following renewed kinetic exchanges between the Iran Revolutionary Guard Corps and the U.S. That pushed up crude oil risk premiums, though by far less than during the initial stages of the conflict. A protracted Iranian stranglehold on the Strait of Hormuz remains a risk.
- European political tensions are rising again. In the U.K., Keir Starmer’s resignation as prime minister has opened the door to a Labour Party leadership transition. In France, Marine Le Pen received court approval to run in the 2027 presidential election. Her anti-establishment stance, particularly toward the European Union, could increase regional risks.
- Robust U.S. growth relative to its peers and higher yields have boosted the U.S. dollar. We expect a wider, volatile range for the U.S. dollar with a near-term upside bias.
- The key elections in 2026 are the U.S. midterms and Brazil’s presidential election. Market-friendly presidential elections in Colombia and Peru resulted in the election of Abelardo Espriella and Keiko Fujimori, respectively.
- Tightening races cloud math for U.S. Senate: Headlines regarding control of the Senate are swirling following the sudden passing of Senator Lindsey Graham (R-SC) and the Democratic candidate dropping out in Maine, while open-seat races in Iowa, Ohio, and Texas remain competitive. Regardless of the outcome, Senate margins are likely to stay narrow, suggesting limited prospects for major legislation in 2027, particularly with a Republican White House.
Risks to our outlook
- Expansion or escalation in the Iran conflict, particularly regarding the Strait of Hormuz, could result in sustainably higher inflation by disrupting the global oil supply chain. That would hinder declines in U.S. interest rates and hamper global 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, robust debt issuance, and mounting interest costs, 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.
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