Key Takeaways
- A prolonged oil-supply disruption is likely to cause inflation to re-accelerate and push the 10-year U.S. Treasury yield toward the upper end of our revised 4.5–5.3% year-end range.
- The Federal Reserve’s new hiking cycle is driven less by domestic demand than by the duration and severity of the oil shock.
- Deglobalization, fiscal pressure, and geopolitical constraints point to structurally higher rates and volatility, increasing the value of diversification, inflation protection and duration management.
Raising our interest rate outlook
In our 2026 Mid-Year Outlook, we set a target range of 4.0–4.8% for the 10-year U.S. Treasury yield. A longer-than-expected disruption to oil supply has already driven yields above the high end of that range, and we now see a meaningful risk that supply will remain restricted for several more months. If it does, inflation would likely stop moderating and begin to reaccelerate. In response, we are raising our year-end target range for the 10-year U.S. Treasury yield to 4.5–5.3% (Exhibit 1). The correlation between interest rates and oil prices has never been higher (Exhibit 2), making oil the main factor determining whether interest rates finish the year near the low or high end of our range.
The Fed hiking cycle has begun
In our July 27 FOMC preview, we forecast that if oil prices remained elevated, above $80 per barrel, through August, the U.S. Federal Reserve would likely begin a rate hiking cycle. With yesterday’s policy rate increase, the Fed has entered its first hiking cycle since 2022–2023, joining the European Central Bank and the Bank of Japan. The Fed has raised its policy rate range by 25 basis points (0.25 percentage points) to 3.75–4.00%, and the market is pricing in another hike by the end of the year and two more hikes by the end of 2027.1 In our view, the duration and magnitude of this hiking cycle also depend on how long the oil supply disruption lasts. Unless global oil supply meaningfully recovers by mid-November, we expect the Fed to raise rates at both remaining meetings this year, in October and December.
Higher for Longer, by Design
Deglobalization raises the floor
The reversal of the multi-decade globalization trend is inherently inflationary. The most visible driver is trade friction: a decade of rising tariffs, quotas, and cross-border fees has pushed input costs higher (Exhibit 3). But that is only part of the story. Labor mobility has declined. Supply-chain security now outranks cost in corporate sourcing decisions. Military conflict and tighter regulatory scrutiny of cross-border deals and joint ventures have narrowed the field of viable partners and routes. Add the erosion of U.S.-guaranteed shipping security, with critical chokepoints increasingly monetized or controlled by others, and the scramble to lock up oil, critical commodities, and rare earths. The result is a persistent cost premium that did not exist a decade ago. Efficiency was the organizing principle of the old system. Resilience is the organizing principle of the new one, and resilience costs more.
Fiscal policy reinforces the higher-rate story
The rise of populism has coincided with the declining influence of deficit hawks, across party lines and national borders. U.S. federal debt recently surpassed $40 trillion, driven by a deficit that has rarely been larger outside periods of major war or recession (Exhibit 4). The options for reducing this debt burden are straightforward: spending cuts, tax increases, or inflation. But with mandatory spending, net interest expense, and defense together accounting for more than 85% of government expenditures (Exhibit 5), meaningful cuts will be difficult to achieve, as the DOGE efforts demonstrated. That leaves tax hikes and inflation. In the near term, inflation is the more likely lever given the absence of deficit hawks. Over the long term, however, higher taxes may prove difficult to avoid. This is not just a U.S. phenomenon (Exhibit 6). Widening deficits abroad are pulling global interest rates higher in tandem (Exhibit 7).
Two Wildcards for the Rest of the Year
Liquidity is strong but fading
Economic and corporate profit growth has been strong, but the tailwinds are beginning to fade. Lower real incomes, slower earnings growth, and possible fiscal tightening all point to greater vulnerability to demand destruction and tighter liquidity against the backdrop of accelerating inflation and higher interest rates. Liquidity remains robust, but as we noted last month (Peak Liquidity?), some key drivers of record liquidity are moderating as rates rise. Meanwhile, the Nasdaq 100 and small caps are well off their highs and U.S. high yield corporate bonds have begun to sell off amid widening credit spreads (Exhibit 8).
Geopolitics: the key swing factor
With so much hinging on oil prices, the developments in the Middle East are likely to be the main driver of interest rates through year-end. President Trump has indicated that he does not expect the Strait of Hormuz to reopen until after the midterm elections, and Kalshi betting markets suggest the probability of significant Hormuz traffic by the end of the year has fallen to just 9% (Exhibit 9).2 The situation has been exacerbated by Houthi control of the Bab el-Mandeb access to the Red Sea (another critical waterway), drone strikes that damaged Saudi Arabia’s East-West pipeline (used to bypass the Strait of Hormuz), and sharply reduced refining capacity in Russia amid its war with Ukraine. As a result, U.S. gasoline prices are well above $4 per gallon while diesel, which is heavily used by trucks and heavy machinery, is well above $6 per gallon.3
What It Means for Portfolios
Portfolio resilience in a higher-rate environment
Given the structural drivers of higher inflation and interest rates, we expect rate volatility to remain elevated. Investors may want to consider adjusting portfolio exposures to better accommodate this backdrop.
- Reduce interest rate risk. Income-seeking investors can consider public dividend-paying equities and alternative investments such as private credit, real assets, and structured investments that can provide alternate sources of income and offer some combination of less interest rate risk (through duration) or greater inflation protection. Investors seeking more resilient total returns could consider multi-strategy hedge funds, which tend to thrive during periods of high or volatile interest rates.
- Actively manage duration. In an environment of structurally higher interest rates, managing duration allows investors to be more tactical in their exposure to interest rate risk.
- Combine income with downside protection. In addition to providing income, structured investments also offer the benefit of defined downside protection.
- When in doubt, diversify. Diversified portfolios are generally better positioned to weather large swings in inflation or interest rates.
SOURCES
- Bloomberg Index Services, as of September 16, 2026.
- BBC, Iran war won't end until after crucial November elections, says Trump, September 10, 2026.
- Bloomberg Index Services, as of September 16, 2026.
INDEX DEFINITIONS
Bloomberg Financial Conditions Index: The Bloomberg U.S. Financial Conditions Index is a Z-score tracking the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.
Bloomberg U.S. Corporate High Yield Bond Index: The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded.
Global Supply Chain Pressure Index: The GSCPI tracks the state of global supply chains using data from the transportation and manufacturing sectors. The index is updated at or shortly after 10:00 a.m. on the fourth business day of each month.
Nasdaq 100 Index: An index comprised of equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange. It is a modified capitalization-weighted index.
Russell 2000 Index: Measures the performance of approximately 2,000 small-cap US equities. Stocks in the Russell U.S. indexes are weighted by their available (also called float-adjusted) market capitalization.
S&P 500 Index: The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 of the top companies in leading industries of the U.S. economy and covers approximately 80% of available market capitalization.
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