2026 USD Bond Market Outlook: Slowing US Growth and Gradual Yield Curve Normalization

Highlights:

• As we look towards 2026, the slowdown in The US economic expansion will prompt the Federal Reserve to continue its rate-cutting phase, leading to a steady normalization of the yield curve throughout the year. That said, persistent inflation stickiness could slow its descent, constraining the Fed's ability to loosen monetary policy more aggressively.
• Under these conditions, we see strong appeal in 5- to 10-year US Treasuries. Declining rates will boost prices for bonds with moderate durations, while this segment sits on the steepest part of the yield curve, offering enhanced roll-down returns. Investors may consider extending durations gradually and allocating to intermediate maturities to capitalize on the curve's normalization.
• We continue to favor investment-grade bonds, which still offer compelling absolute yields and solid defensive qualities. In contrast, high-yield bonds provide minimal spread premium over investment-grade options, hovering near historic lows, with insufficient risk compensation. Without adequate buffers, high-yield bonds could face widening spreads if the US economy experiences an unexpected downturn.

Labor Market Shows Ongoing Weakness

Recent months' employment data reveal a clear softening in the US job market. In October, the unemployment rate climbed to 4.6%, marking a more than three-year high, while nonfarm payrolls added just 64,000 jobs, continuing a downward pattern with underwhelming results (see Chart 1).

Chart 1: US Nonfarm Payroll Growth and Unemployment Rate

Moreover, revisions to nonfarm payroll figures have grown substantially larger in recent times. For the first nine months of 2025, the average monthly downward adjustment reached about 60,900 jobs, far exceeding prior years' levels (see Table 1). This underscores genuine labour market fragility, which led the Fed to implement three consecutive 25-basis-point rate cuts in September, October, and December to address mounting employment risks.

Table 1: US Nonfarm Payroll Net Revision Mean (2nd Revision  –  Initial Estimate)

Robust AI-Related Investments Expected to Bolster US Growth

Although retail sales growth tapered off in 2025, weakening the consumer spending that has long driven US economic expansion, surging AI-driven investments have provided a counterbalance. In the first half of 2025, non-residential investment—essentially business capital spending—unusually outpaced consumption, emerging as the primary engine of GDP growth (see Chart 2).

Within this, AI-linked investments accounted for nearly all of the non-residential surge, contributing over one percentage point to overall growth—well above the average 0.3 percentage points from the prior four years.

Chart 2: US GDP Growth Contribution

With semiconductor sales maintaining strong momentum (see Chart 3) and tech firms projecting elevated capital expenditures for 2025, even a slight cooling in spending over the next two years could moderate GDP expansion. Still, AI investments are poised to sustain the economy and partially offset the drag from slower consumption.

Chart 3: US Retail Sales and Semiconductor Sales

Goods Inflation Shows Renewed Uptrend

On the inflation front, recent figures show core PCE and core CPI holding at elevated year-over-year rates of 2.8% in September and 2.6% in November, respectively—well above the Fed's 2% target.

Breaking down core CPI components, while services inflation has eased slightly, goods inflation has been climbing since April, keeping overall pressures high without signs of abatement (see Chart 4).

Chart 4: Structure of US Core CPI

Driving this goods inflation rebound are categories like vehicles, auto parts, and household goods, many of which rely on imports. This suggests the uptick stems from policy shocks and supply chain cost pressures rather than isolated events. Influenced by tariffs, the ISM Manufacturing survey's business price index (input costs) spiked in April to its highest since June 2022 (see Chart 5). In household goods, subsectors such as tools, hardware, outdoor equipment, furniture, and bedding have all risen in tandem, indicating broad-based inflationary trends.

Chart 5: US Core CPI & ISM Manufacturing Report on Business Prices Index

As businesses replenish inventories and pass costs on to consumers, core goods prices may remain under upward pressure. However, with consumer sentiment subdued, companies could absorb part of these expenses, limiting sharp increases. Tariff‑related inflation effects are also likely to be one‑off, tempering price pressures.

Services Inflation Remains Sticky, Slowing Overall Decline

Meanwhile, services inflation, though moderating, exhibits strong persistence and a gradual pace of cooling, remaining at lofty levels. Housing inflation, which accounts for a full 46% of core CPI, still stands at 3.0% due to the persistence of market rents (see Chart 6), significantly propping up the broader measure.

Chart 6: US Shelter CPI and Rent Index

Since the pandemic, wage growth has stayed elevated. And recent accelerations in medical and insurance prices have also kept core services CPI as high as 3.0% (see Chart 7).

Chart 7: US Wage Growth and Core Service CPI

Notably, while headline inflation appeared to cool sharply in November, the data are somewhat distorted. The government shutdown halted the October price survey, so the Bureau of Labor Statistics largely carried forward September figures and relied on limited non‑survey sources, leaving November inflation readings—particularly for housing costs—artificially low compared to the previous September numbers. The statistical deviation is expected to gradually correct over the coming months, leaving room for a rebound in inflation thereafter.

Taken together, the tenacity of services inflation combined with rising goods pressures means reaching the 2% target will take time. Even as the Fed balances employment concerns, these dynamics will cap monetary easing. We anticipate a slowdown in US growth leading to about two rate cuts in 2026.

At the December FOMC meeting, the Fed opted for a 25-basis-point cut, lowering the rate to the 3.50%-3.75% range as widely expected, though the vote split 9-3, the most divided since 2019. The December dot plot revealed stark differences in 2026 rate projections: four officials foresee no cuts, four expect 25 basis points, four anticipate 50 basis points, three predict rates below 3%, and three advocate a 25-basis-point hike. This spread highlights deep inconsistencies in views on inflation and the economy.

Given President Trump's repeated public criticisms of the Fed’s hawkish officials, alongside Chair Powell's term ending in May 2026 and Trump's indication of a successor— with Kevin Hassett emerging as a frontrunner—political influences could shape future rate paths, injecting uncertainty and volatility.

Steepening Yield Curve Offers Duration Opportunities

Heading into 2026, as the Fed advances its cutting cycle, short- to medium-term rates should trend lower. Yet, inflation and fiscal risks will keep long-end rates relatively firm, allowing the yield curve to normalize progressively. Since the September cut, 10-year Treasury yields have risen by more than 5 basis points, illustrating that amid ongoing inflation and fiscal strains, bond yields may not mirror policy rates downward and could fluctuate or even rebound.

In this backdrop, 5- to 10-year Treasuries stand out as attractive. Falling rates will elevate prices for these intermediate-duration bonds, and their position on the curve's steepest slope offers superior roll-down returns— the price appreciation that arises as maturities shorten and yields move lower (see Chart 8).

Chart 8: US Treasury Curve

Regarding short-term bonds, yields remain elevated, and cuts could deliver price gains, so holding them makes sense. As rates decline methodically, though, shifting allocations toward longer durations in the intermediate range could help seize normalization benefits.

Preference for Investment‑Grade Corporate Bonds

In the corporate bond space, with credit spreads at historic tights and macroeconomic uncertainties lingering—potentially leading to spread widening—we uphold our tilt toward investment-grade issues.

Currently, the high-yield spread premium over investment-grade is near record lows at around 220 basis points, well below the long-term average of 365 (see Chart 9). From a valuation standpoint, this offers scant reward for taking on elevated credit risk, diminishing high-yield's relative allure.

Chart 9: High Yield - Investment Grade Corporate Bond Yield Premium

By contrast, investment‑grade bonds yield around 4.4%, way above the 15-year average of 3.2%, providing a more enticing return than sovereign debt. Fundamentals across the investment‑grade universe remain solid, default risk is low, and these bonds are less vulnerable to spread widening during periods of economic slowdown. This enhances portfolio defensiveness and stability.

Investors may consider some of our bond selection listed in Table 2 below – these are all investment-grade rated bonds which we covered earlier in 2025.

Table 2: Selected Investment-Graded Bonds

Conclusion

As we look towards 2026, the slowdown in US economic expansion will prompt the Federal Reserve to continue its rate-cutting phase, leading to a steady normalization of the yield curve throughout the year. That said, persistent inflation stickiness could slow its descent, constraining the Fed's ability to loosen monetary policy more aggressively.

Under these conditions, we see strong appeal in 5- to 10-year US Treasuries. Declining rates will boost prices for bonds with moderate durations, while this segment sits on the steepest part of the yield curve, offering enhanced roll-down returns. Investors may consider extending durations gradually and allocating to intermediate maturities to capitalize on the curve's normalization.

We continue to favor investment-grade bonds, which still offer compelling absolute yields and solid defensive qualities. In contrast, high-yield bonds provide minimal spread premium over investment-grade options, hovering near historic lows, with insufficient risk compensation. Without adequate buffers, high-yield bonds could face widening spreads if the US economy experiences an unexpected downturn.