It was a good year for most bond investments in 2025. High starting yields, price appreciation for high-quality bonds, and a downtrend in yields led by Federal Reserve rate cuts combined to produce strong returns.

We expect another good year in 2026, although returns might not be as robust as they were last year. Starting yields are lower, and we see less room for yields to fall (and prices to rise) as an expected resilient economy likely will limit the scope for Fed rate cuts.

We expect the yield curve to continue to steepen. The Federal Reserve lowered interest rates three times in 2025 but is expected to cut only one or two more times this year. That should pull short- and intermediate-term Treasury yields lower, but the 10-year Treasury yield should hold near 4% given sticky inflation, an expected increase in Treasury supply to finance federal deficits and rising global bond yields.

But even the best-laid plans can go awry when circumstances change. The year has already started off with a bout of volatility and there are plenty of potential catalysts for more. Consequently, we have compiled a list of what could go wrong and what it would mean for bond markets.

1. Upside or downside surprises to inflation. After peaking in 2022, inflation has been trending lower, but the downward progress has stalled a bit lately. The 12-month change in the headline Consumer Price Index (CPI) has held between 2.3% and 3.5% since the beginning of 2024; the 12-month change in core CPI, which excludes volatile food and energy prices, held at 2.6% in December after moderating in November, but prior to that had held between 2.8% and 3.4% for 17 straight months.

We expect inflation to remain a bit sticky, holding above the Fed's 2% target, for the near term given the resilient economy, but there appear to be both risks to the upside and the downside.

A significant weakening of the labor market could pull inflation lower if it slows down consumer spending. The labor market picture has been a bit mixed lately, with the December unemployment rate falling to 4.4% to reverse some of the recent rise, but job growth remains tepid. On a three-month-average basis, nonfarm payroll gains have been negative since October. Lower inflation could result in more rate cuts, a flatter yield curve, and more potential price appreciation for Treasuries.

There are risks to the upside as well. Fed easing has kept financial conditions easy, and fiscal stimulus from last year's "One Big Beautiful Bill Act" could support a pickup in consumer spending. Tariffs appear here to stay, even if the outlook for the legality of the International Emergency Economic Powers Act (IEEPA) is uncertain. While tariffs haven't necessarily driven headline inflation rates much higher, they have generally lifted the prices of imported consumer goods by varying degrees.

Meanwhile, consumer and business surveys suggest that price increases are still a concern. The prices-paid components in both the Institute for Supply Management (ISM) Manufacturing and Services surveys highlight this risk, as both indexes have increased from the recent lows. Treasury yields would likely rise if inflation were to reaccelerate, with long-term Treasury prices falling the most given their high interest-rate risk.

2. A weaker economy. The recession that many feared when the Fed aggressively hiked rates in 2022-2023 never arrived, but risks are still present. Despite the strong headline growth, it's generally a bifurcated economy, often referenced as the "K-shaped" economy. Not everyone has benefitted from the above-trend growth over the last few years.

Slower growth would likely result in more Fed rate cuts and lower Treasury yields all across the curve. High-quality bond investments would likely benefit in this environment as lower yields would result in more price appreciation.

Riskier investments, like high-yield bonds and bank loans, would likely underperform in a slowing economy. Corporate profit growth would likely stall or turn negative, making it more difficult for highly indebted companies to remain current on their bond obligations. High-yield bond defaults have held near their long-term averages for the last two years, and they would likely edge higher.

The corporate bond markets aren't priced for slower growth ahead. Credit spreads—the extra yields that corporate bonds offer above comparable Treasuries—remain near their all-time lows, suggesting very little investor concern about the health of the economy or corporate balance sheets. If the outlook deteriorates, investors tend to demand higher relative yields to compensate for the potential credit losses if defaults do pick up. That pulls corporate bond prices lower relative to Treasuries.

We have a neutral outlook on high-yield bonds even if growth holds near its trend given the low relative yields. If economic growth were to slow, or worse, a recession arrived, high-yield bond and bank loans would likely underperform U.S. Treasuries.

3. Changes at the Fed. The beginning of each year brings the annual rotation of voters on the Federal Open Market Committee (FOMC). Governors are permanent voters, as is the president of the Federal Reserve Bank of New York who serves as the committee's vice chair, but district bank presidents vote on a rotating basis. While the two district presidents who dissented at the December FOMC meeting in favor of holding rates steady will rotate out of voting, two incoming voters appear to lean on the more hawkish side—Cleveland Fed President Beth Hammack and Dallas Fed President Lori Logan.

Potential changes to the Board of Governors may have more implications, however. Governor Stephen Miran's term ends at the end of January, and whoever fills that may become the Fed Chair once Jerome Powell's term ends at the end of May. President Donald Trump has made it clear he prefers a chair that shares his views on lower interest rates, so it's reasonable to assume that Miran's replacement will be more dovish than Powell.

While Powell's term as chair ends in May, his term as governor runs until January 2028. He hasn't disclosed his post-chair plans yet, and it's possible he will vacate his governor position later this year. Meanwhile, Governor Lisa Cook's future is in question as administration is attempting to remove her from her position.

The reported threat of a criminal investigation into the Federal Reserve muddies the outlook even more as it raises questions around both Federal Reserve independence and the outlook for new potential governor appointments. Following the announcement, Senator Thom Tillis stated that he will "oppose the confirmation of any nominee for the Fed—including the upcoming Fed Chair vacancy—until this legal matter is fully resolved." ¹

There's plenty of uncertainty around the path of monetary policy as the dot plot below illustrates. There's a wide range of views among committee members, and it may be difficult to build consensus this year. But if we see turnover at the Board of Governors and the members are dovish, then the Fed would likely cut rates more than we and the markets currently expect.

4. Geopolitical risks. The political outlook is unstable amid a number of policy changes. Domestically, the loss of subsidies for the Affordable Care Act and their impact on the government shutdown has been a source of dispute, along with immigration policies. In the global economy, the U.S. move to remove Venezuela's president has raised questions about future foreign policy moves.

While markets have handled the various international conflicts easily, the implications for oil prices, the U.S. dollar, economic growth, and the budget are a bit unknown. It would not be surprising to see future bouts of volatility due to the instability. Treasury market volatility, measured by the ICE BofA MOVE Index shown below, is near its four-year lows. Treasury yields could move up or down more than expected if volatility picks up this year.

Our base case—what we believe to be the most realistic expected scenario—calls for steady growth and sticky inflation, but it's always important to consider alternative scenarios and how they may impact investments.

We suggest investors consider intermediate-term maturities—those with average yields in the four- to 10-year range—given our outlook for a steeper yield curve. Focusing too much on short-term investments introduces reinvestment risk as the Fed cuts rates, but focusing too much on long-term investments means high interest rate risk if yields rise due to sticky inflation or the increase in supply.

We continue to suggest an "up in quality" investment theme mainly due to valuations. Treasuries, agency mortgage-backed securities, and investment grade municipal and corporate bonds would fall under that umbrella. Investors can consider riskier investments in moderation, but their low relative yields mean there's little margin for error if the economy slows.