What Changed for Interest Rates in 2026?

Key Takeaways

• The year began with an optimistic outlook, built on solid fundamentals and an expectation that interest rates would fall.
• A geopolitical oil shock in late February upended that picture, driving energy prices and inflation higher
• The market has since flipped from expecting interest rate cuts to bracing for interest rate hikes, and bond yields have risen across the board.
• The central question now is whether inflation remains largely an energy story or spreads more broadly through the economy.
• In response, we are positioning our bond holdings to take advantage of today's higher rates while limiting interest risk if rates rise further.

A Favorable Start

The market entered 2026 on relatively solid footing. Corporate earnings remained strong, inflation had largely stabilized after a modest tariff-driven uptick in late 2025, and the labor market appeared resilient despite some early signs of softening, including slower hiring activity and a gradual increase in continuing unemployment claims.

Against this backdrop, investors broadly expected the Federal Reserve to keep lowering interest rates as inflation drifted back toward its target.

Falling interest rates are good news on two fronts. They lift bond prices, especially for longer-term bonds, and they support stock prices, because lower rates make future company profits more valuable today.

While there were reasons for caution underneath, including those early labor-market cracks and questions about whether the heavy AI spending by the largest technology companies could last, most of the evidence still pointed toward continued growth.

The Shock

Then, on February 28, 2026, the picture started to change. The United States and Israel launched coordinated strikes on Iranian military, nuclear, and leadership targets, and the conflict spread across the region within days.

The economic consequences followed shortly thereafter. On March 2, 2026, the Strait of Hormuz was effectively closed. This narrow shipping lane carries roughly 20% to 25% of the world's oil supply, so its closure resulted in fuel shortages and a sharp jump in oil prices.

In the months since, headlines have cycled through potential ceasefires, partial reopenings, renewed strikes, and further negotiations. Despite these developments, reliable passage through the strait was never restored. Oil prices remained elevated and volatile throughout the period.

The implications extend well beyond the energy sector. Oil is a key input across the economy, affecting transportation, manufacturing, and many other goods and services. A sustained increase in oil prices does not remain isolated for long, and uncertainty around the duration of the disruption is what changed the interest-rate outlook that had looked favorable in January.

Where We Stand Today

The shock shifted expectations from disinflation and rate cuts toward concerns about higher inflation and rising interest rates.

So far, inflation data has shown a meaningful increase in energy inflation, while most other components have risen only modestly. This suggests that the broader economy is still absorbing higher oil prices and has not yet fully passed those costs to consumers.

The concern is that the energy shock does not remain contained. If higher fuel and input costs begin filtering into transportation, manufacturing, wages, rents, and services, inflation could become more widespread, and the Federal Reserve may be forced to raise interest rates to bring it back under control.

The market has increasingly moved toward this view. Bond yields are higher across the curve, and the market is now pricing in roughly a 70% probability of rate hikes by year-end.

Going Forward

In just a few months, the market narrative shifted from cooling inflation and expected interest rate cuts to concerns that inflation could remain elevated and interest rates could move higher. The favorable backdrop that opened the year has given way to a less certain outlook.

Against this backdrop, within fixed income we are taking advantage of higher interest rates by reinvesting proceeds from maturing bonds at today's more attractive yields. At the same time, we are keeping duration short to limit interest-rate risk should rates continue moving higher. Staying short also allows us to reinvest at prevailing rates more frequently, which can be beneficial if yields remain elevated or rise further.

Within equities, we continue to focus on businesses trading at reasonable valuations that do not rely heavily on cash flows far into the future. Because higher interest rates weigh most heavily on the present value of distant earnings, favoring companies with durable, nearer-term cash flows can help reduce the impact rising rates may have on equity valuations.

While the outlook has become less certain, our approach remains unchanged. We continue to focus on building resilient portfolios, taking advantage of opportunities created by changing market conditions, and maintaining the discipline needed to navigate a wide range of outcomes over time.