Fixed Income Market Outlook 2026: Steady but Restrained

These three factors will drive fixed income markets in 2026. We summarize them here and go into greater depth below.

• Federal Reserve Policy: The Fed is likely to pause in early 2026, then continue its rate-cutting cycle. At present, most Fed watchers expect two cuts in 2026, bringing the federal funds rate to the 3.0% to 3.5% range by year-end. The goal, as always, is to support the labor market, which is holding up fairly well but has been softening, without pushing inflation higher. Inflation is close to 3% versus the Fed’s 2% target, which could limit the extent of any rate cuts.
• Upward pressure on rates from persistent inflation and government borrowing: Inflation is expected to hover around 3% due to high tariffs, a weakening dollar, and strength in the services sector. Large and rising U.S. fiscal deficits mean increased Treasury issuance, which, along with inflation concerns, may keep long-term Treasury yields high, steepening the yield curve.
• Resilient corporate fundamentals: The U.S. economy is projected to experience modest, above-trend growth, largely supported by AI-driven business investment and ongoing consumer spending. That should support fundamentals, keeping investment grade corporate bond spreads tight.

The Fed, rate cuts, and where the 10-year Treasury yield will go

Views are split on whether the employment picture or inflation will dominate Fed rate cut decisions during 2026, but most bond market watchers expect the Federal Reserve will be under pressure to keep cutting short term rates in 2026. At its December 2025 meeting Chairman Powell, whose term ends in May, indicated the Fed may pause rate cuts, at least in the first part of the new year.

Bond investors know the Fed has little control over anything but the short end of the yield curve, including the bellwether 10-year Treasury yield that, among other things, drives home mortgage rates. Bond bulls expect the 10-year yield to decline toward 3.75% in 2026, but many others say a “bear steepening” could push that yield as high as 4.50% or even higher. If pressure from the Trump Administration leads the Fed, under a new Chair, to cut the fed funds rate more than once or twice, investors would see that as a loss of Fed independence, increasing inflation risk. At close to 3%, inflation is already well above the Fed’s long-term target of 2%, and further pressure to cut rates could cause long-term bond investors to revolt and sell longer maturity bonds (so-called bond vigilantism). That would drive longer-term yields higher, and the yield curve would steepen.

Keep in mind: Regardless of who takes over as Fed chair, expect to see large T-bill issuance to fund the growing deficit and roll over maturing U.S. debt. If the supply of T-bills increases significantly, that could push short-term yields higher. A wild card here is the potential for growth in stablecoins, which are primarily backed by high quality, short-term paper like T-bills. That could soak up some of the T-bill issuance needed to pay the government’s bills.

Inflation, the economy, and government borrowing

Uncertainty about tariffs—including exemptions from them and potential increases—along with significant shifts in U.S. policies toward the rest of the world—are causing some countries to hold more of their reserves in currencies other than the US dollar. While most global trade is still conducted in USD, the dollar’s share of central bank reserves slipped from roughly 71% in the year 2000 to about 59% last year, according to the International Monetary Fund. This contributed to downward pressure on the dollar in 2025, and further “de-dollarization” would raise the cost of imported goods, contributing to inflation that could cause longer-term rates to rise.
 
Economic growth in 2026, measured in terms of gross domestic product (GDP), is likely to be supported by tax cuts from the One Big Beautiful Bill Act, and by lower short-term rates engineered by the Fed in 2025. The tax cuts in the OBBB tend to favor higher-income consumers and corporations, whose spending should keep economic growth at slightly above the long-term trend of about 2% to 2.5%. Spending and growth should boost tax receipts, but not enough to offset the tax cuts from the OBBB (tariff income helps a bit, but not much), so the deficit is likely to keep rising.
 
Keep in mind: Government borrowing as a percent of GDP is now the highest it has ever been, including the WWII era, except for a very brief spike when the economy all but shut down due to the COVID-19 pandemic. Unless tax receipts grow significantly or meaningful spending cuts are made, the government has to borrow more just to pay the interest expense on its debt. The growing supply will put upward pressure on Treasuries yields, especially if demand weakens as foreign governments hold less of their reserves in U.S. Treasuries.

Credit Markets

According to SIFMA, U.S. corporations issued roughly $1.7 trillion in investment-grade debt in 2025, nearly matching the all-time high set in 2020. The surge in issuance last year was attributed to borrowings to finance massive AI infrastructure build outs, refinance maturing debt, and provide funding for a strong M&A pipeline. The bond market could see record issuance in 2026 as both AI investments and refinancing needs are likely to increase.

While overall credit fundamentals appear to be strong and would be supported by solid economic growth, lower-quality, highly leveraged segments of the market are showing signs of stress, particularly in private credit. Recession fears have faded, but a significant weakening in the labor market, perhaps due to AI replacing workers, could lead to a meaningful economic slowdown, which would likely cause credit spreads to widen.

Some expect a “Goldilocks” economic scenario in 2026 (moderate growth, restrained inflation) which would keepdefault risk low.  Accommodative liquidity from banks and private creditsourcescould indirectly buoy the credit market by supporting economic growth and borrowing demand. Municipal bonds head into 2026 with attractive taxable-equivalent yields and a solid credit outlook for the year based on tax receipts from both sales taxes (driven by solid consumer spending) and income taxes owed on strong stock market returns in 2025. A weakening dollar coupled with growth in many emerging market economies are leading a growing number of investors to consider emerging market debt.

Keep in mind: Many analysts believe companies have yet to pass along the cost of tariffs to their customers as they have been working down inventories built up early in 2025 and have shifted supply chains to keep input costs from rising too much. If tariffs start to bite into profit margins, that would either weaken corporate fundamentals or push companies to pass higher costs on to consumers, increasing inflation. Another possibility: tariffs could be lowered through bi-lateral trade negotiations.

In sum, 2026 may deliver steady but unexceptional returns for fixed income investors, with yields rising modesty and credit spreads a bit wider. Bond returns are expected to be driven mostly by interest income (yield) rather than price appreciation, as there appears to be little room for yields to decline. Many market watchers expect the yield curve to steepen, especially if the Fed is under pressure to lower rates as that would worsen inflation fears. In a portfolio context, fixed income is likely to play its traditional role as a stabilizer, especially given macroeconomic uncertainties that include inflation pressure and the impact of AI on the U.S. economy. Given the potential for market volatility and the range of possible economic outcomes, active management is likely to be essential to identify opportunities in areas ranging from corporates to emerging market debt and securitized credit. The middle part of the yield curve is expected to offer the best trade-off between yield and duration risk, given the risk of a steeper curve as we move through the year.

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