Markets are pricing in at least one more interest-rate increase from the U.S. Federal Reserve this year following hotter inflation data and a more hawkish tone from policymakers.
Consumer prices rose 3.5% in the year through June, less than markets expected and a slowdown from 4.2% in May, which was the highest annual increase in three years. Meanwhile, new Fed Chair Kevin Warsh has emphasized that restoring price stability is his top priority, and the median projection from Federal Open Market Committee (FOMC) participants points to one rate hike in 2026.
Morgan Stanley Research, however, sees a different path.
“We expect a lower inflation trajectory that keeps policy on hold this year, potentially followed by two rate cuts in 2027 as inflation gradually normalizes,” says Michael Gapen, Chief U.S. Economist for Morgan Stanley Research. “The main source of this divergence is our more constructive view on the inflation outlook relative to both markets and the Fed.”
For fixed-income investors, a stable-to-easing rate environment could support government bonds and reinforce the case for maintaining exposure to high-quality income-generating assets.
“A broadly unchanged Fed policy-rate path in 2026 and the prospect of AI-driven productivity gains should keep real yields elevated,” says Vishy Tirupattur, Chief Fixed Income Strategist and Director of Quantitative Research at Morgan Stanley.
Why the Fed May Hold Rates Steady
Morgan Stanley Research expects the Fed to keep rates unchanged for several reasons. First, inflation appears to be moderating as the pass-through from higher tariffs to consumer prices is nearing completion, reducing a key source of pressure. In addition, leading indicators suggest rent and housing inflation continue to cool.
Lower energy prices should also help ease inflation. After surging above $120 a barrel during the height of tensions surrounding the conflict in Iran, Brent crude futures fell below $70 in the final week of June as geopolitical risks eased. Morgan Stanley Research commodity strategists expect Brent crude to end 2027 around $70 a barrel.
Recent labor market data further reinforce Morgan Stanley Research’s expectation that the Fed will leave rates unchanged this year, instead of raising them. The U.S. economy added 57,000 jobs in June, well below the consensus estimate of 115,000, while payroll gains for the previous two months were revised lower by a combined 74,000 jobs.
“The data suggests labor demand is cooling after a stronger spring,” Gapen says. “Based on what we know now, we think patience will win the day and the Fed will not hike in July.”
Financial Conditions Already Reflect Tighter Policy
Meanwhile, financial markets have already done much of the Fed’s tightening, notes Martin Tobias, U.S. Interest Rate Strategist for Morgan Stanley Research.
Tobias and his team developed a financial conditions index modeled on a framework used by the Federal Reserve Bank of San Francisco. The index incorporates 12 market variables—including Treasury yields, mortgage rates and corporate borrowing spreads—to estimate the effective level of monetary policy implied by financial conditions.
Since the start of the Iran conflict, the index suggests financial conditions have tightened by an amount equivalent to four 25-basis-point rate increases.
“In essence, markets have already priced in the persistent inflation risks identified by the FOMC by pushing the implied Fed funds rate path higher,” Tobias says. “The Fed doesn’t need to deliver on the tightening in financial conditions in response to backward-looking data to retain credibility. It just needs to react to incoming information.”
Warsh has signaled that under his watch the Fed will give fewer hints about where rates are headed, which gives investors less to anchor to between central bank meetings. That means big economic releases, like inflation and jobs reports, can move expectations more and short‑term rates may swing more as markets reprice what the Fed might do next.
“Less forward guidance should mean more policy surprises—and therefore greater realized volatility,” Tobias says. “We continue to see attractive medium-term value in short- and intermediate-maturity bonds,” which may be less sensitive to the volatility in short-term rates than longer-duration government bonds.
Fixed Income Outlook
Against a backdrop of less forward guidance and greater potential for policy surprises, Morgan Stanley Research’s views emphasize where income and relative value appear compelling. While equities remain the preferred engine of portfolio returns, fixed income has regained an important role as a source of income, diversification and stability.
Elevated yields and a generally supportive economic backdrop create a constructive environment for bond investors, but record issuance across many sectors is likely to limit broad-based price appreciation. As a result, returns are expected to be driven more by income and security selection than by falling yields or significant spread tightening, reinforcing fixed income’s role as a portfolio stabilizer rather than a primary return driver.
Here’s a breakdown for fixed income investors:
- Government bonds appear positioned for gradual improvement as inflation likely moderates and the Fed remains on hold. Morgan Stanley Research projects the yield on the 10-year U.S. Treasury to decline to approximately 4.25% by year-end and 4.20% in 2027, supporting a constructive—but not overly bullish—outlook for U.S. government bonds. Relative value opportunities may also emerge in parts of Europe and Japan.
- Investment-grade credit remains supported by resilient corporate fundamentals, but supply is likely to be the defining theme. Morgan Stanley Research forecasts a record $2.25 trillion of U.S. investment-grade issuance this year, which is expected to put modest upward pressure on spreads and limit price appreciation. As a result, returns are likely to be driven primarily by income, producing solid mid-single-digit total returns.
- High yield sectors continue to offer attractive income generation opportunities. Morgan Stanley Research expects high-yield bonds to generate total returns of approximately 6% to 7%, supported by a resilient economic backdrop. However, as defaults gradually rise, sector allocation and issuer selection are expected to play a greater role in determining outcomes.
- Structured credit and municipals may offer attractive risk-adjusted income while reinforcing fixed income’s role as a portfolio stabilizer.
