At the start of this year, the anticipation was that interest rates would start to come down given the steady decline in inflation and the softening of the labor market. Fast forward to today, and the US 10 year interest rate now sits ~ 40 basis points higher than it did at the start of the year and the Fed has yet to cut rates in 2026. Talk about a market surprise!

Interest rates tend to serve as the “adult in the room” in financial markets, serving to reign in equity prices along with bond prices by moving to the upside (see reasons for rate moves below). That has not yet happened this year, with equities reaching daily new highs in the face of rising rates. Are interest rates still in charge – and where might we go from here?

In general, there are three forces that move interest rates. Let’s look at each a little closer.

1) Inflation – if there is a belief that inflation will trend higher, rates move higher in response. Why? Bond investors want to be compensated for the loss in purchasing power (ie: keep real rates constant) as inflation rises.

Inflation concerns have be reignited in 2026 – due to Middle East conflict and energy pricing (that carries thru to other areas of economy due to shipping costs, fuel costs, etc). If you need further proof of this dynamic, chart the rise in the 10 year against the rise in crude prices It a near mirror image.  

How will this play out? It remains highly likely that rates will come down as energy prices come down (given the correlation noted above). However, that timing remains in flux due to the on again/off again peace talks with Iran. Interestingly, while short term inflation expectations have picked up, longer run expectations (ie: one year out) are relatively benign, indicating markets do not anticipate these energy related price spikes to endure.

2) Growth Expectations – if investors believe there is going to be a slowdown in the economy, there is a “flight to safety” which pushes demand for bonds up and rates down. On the flip side, if investors are anticipating higher growth in the economy, there is less demand for bonds and rates go up in response.

If you look at the US economy today, there are really three main areas where growth can come from: Consumption/Consumer spending, AI build-out, and residential investment. Today, it seems the growth thesis is all but being driven by the AI build-out, with a little help from consumption in the upper income brackets. Residential investment is basically a non-factor at the moment with stubbornly high rates

If you assume pace of growth in the US will continue (thus leading rates to move higher from here), you are either betting on consumption continuing or AI spending continuing. As for the consumer – if you look underneath the surface, real consumer income is essentially flat year over year and wages by almost every measure are falling for the first time in several years.  How are we going to get massive inflation or growth via more consumption if there is less money to spend? Sure, there is wealth from market gains but we all know a correction hits spending instantly via the wealth effect we’ve discussed. That leaves AI as the primary driver of growth in the US moving forward. While it’s been powerful (major understatement), the rate of change in that growth rate is likely going to slow or flip negative moving forward. At some point, the music stops and it stops quickly.

3) Fed rate expectations – As you know from past discussions on this topic, the Fed controls only the short end of interest rates as a monetary policy tool. However, those changes in the short end carry thru to other parts of the curve as well.  Expectations during 2026 have flipped from cuts to potential hikes due to inflation concerns noted above. Even as the job market falters a bit, concerns over inflation are now dominating the discussion.

Based on a recent research paper I read, 80% of the move in the 10 year since year end has been due to short term rate expectations.  If longer run inflation is pretty much the same as today’s levels, this increase in future fed rate expectations is seemingly being driven by growth expectations than inflation concerns.   However, as noted in #2, it’s hard to see where the growth can come from unless AI keeps growing to the sky.

Where does this leave us? Two main questions are on my mind every day. The first being – will rates turn (and when)? My anticipation is they will turn in short order (and in large magnitude) when and if a resolution in the Middle East is resolved. They may also start to trend lower if there is any other signs of macro weakness, such as weaking labor data or slowing consumer consumption. The timeline for this is unknowable but if you are waiting for a higher peak in rates to rotate into fixed income or to extend duration, you may very well miss your window.

The second question that’s on my mind is why are equities not struggling in this higher rate world? Typically, as rates rise, equities suffer downdrafts as well. This ties back into the math of valuations, namely equity prices are the present value of future cash flows and as the denominators rises (ie: rates), the price should fall. Beyond that simple argument, there is also the well known dynamic that momentum strategies (like the ones driving most market returns today, such as in AI and memory) do not do as well in volatile macro times. Given these past patterns, it’s shocking to see how strong certain parts of market (and the market itself due to the weightings of these sectors) remain. However, a continued march higher in rates could eventually be too much for markets to ignore – even the AI rally.

Trends tend to revert to mean eventually, so my anticipation is either rates will come down or equities will correct slightly to restore the usual correlation. I’m hopeful we hit the former situation first. As always, the path forward is unknowable so stick to your strategies. Rebalance on weakness, trim on strength, deploy new cash into your planned target allocation, resist greed, and stay the course.

Onward we go,