Financial Institutions Quarterly Insights 2nd Quarter 2026

Q2 Strategy 

Interest rates increased slightly during the quarter with the 2-year maturity and the 5- year maturity Treasury movements being the most pronounced. Bond indices posted mixed returns for the quarter. Short-term indices had positive performance while the longest indices declined. The S&P 500 declined 5% returns for the quarter and the NASDAQ declined 7%. The only positive equity market sector during the quarter was energy. 

Interest rates have risen by roughly 50 basis points (0.50%) since the start of the war due, in part, to the increase in the price of oil. Corporate bond credit spreads are only slightly higher than the recent lows. This is because the odds of a recession remain very low. Agency-backed mortgage-backed securities (MBS) offer a few attractive options. Yield spreads are near 100 basis points in a few cases, liquidity is excellent and they have no credit risk due to the implied backing of the U.S. government. An example of a structure we like involves a 20-year maturity and a 5% coupon trades at a price of $100.25. The yield is 4.90%, the yield spread is 95 basis points, and the average life is 4.6 years. The yield spread is higher than most corporates with a BBB credit rating. MBS pools are guaranteed by the issuing agencies but implicitly backed by the U.S. government. Pricing is very transparent and liquidity is typically excellent. It can be a good option for an investor that wants a high-quality intermediate-duration asset. 

The non-agency MBS market has been a favorite sector for some time. They boast some of the highest yields and minimal credit risk. The combination of 15% credit support, low loan-to-value ratios, and few delinquencies makes default a low probability for much of this sector. Yields range from the mid 4.50% to the low 5.0% range. Each deal has a tranche with a 5-year average life which is an appropriate duration for many investors. Yield spreads are higher than what can widely be found in investment grade corporate bonds with a similar duration and liquidity tends to be good in most market environments. 

Corporate bonds generally comprise a significant percentage of many portfolios we manage. They have a higher yield than a similar maturity Treasury instrument. Yield spread usually widens when the economy slows and narrows when economic growth is good. The spread is currently narrow because the economy has been, and is expected to be, good. The spread is the narrowest for the shortest maturity bonds. While we view this asset class as foundation to many portfolios, the current valuation is on the high side from a historical perspective.

As we began 2026 the economic outlook was quite positive. The Fed was expected to lower short-term rates twice and inflation was anticipated to be headed slightly lower. The labor market has been weakening but recession is not currently a concern. The military action with Iran caused oil to rise in price by 50% and inflation expectations rose. In the mind of the market, economic activity will surely soften. How long will this last? A quick end to the conflict will probably mean we can get back to normal quickly. A long conflict has a more severe impact that makes forecasting much more difficult. 

Interest Rate Outlook – The Good, the Bad, and the Ugly 

Last quarter we opined on the various Supreme Court tariff scenarios. The Court’s decision was to essentially strike down nearly all the sweeping “reciprocal tariffs” as well as the “trafficking” tariffs. Essentially, all the tariffs imposed under the International Emergency Economic Powers Act were disallowed, while leaving in place tariffs based on national security and unfair trade practices. Based on late 2025 collections, the disallowance of the tariffs means an annualized revenue stream of between $300 billion and $360 billion is either gone, or it will be attempted to be recreated through a patchwork of alternative workarounds. Absent the political will to broadly raise revenue, or cut expenditures, the lost tariff revenue is significant. Our forecast that trafficking tariffs would stand, along with the $2 trillion deficit, top the list of what was ugly last quarter. 

In terms of beauty being in the eye of the beholder, one constructive development has been the administrative handling of tariff refunds. Contrary to initial expectations of prolonged litigation, the Administration has taken steps to streamline the process, including revoking the original executive orders, reducing legal uncertainty, and implementing a digital claims infrastructure. While this approach may expedite disbursement of funds, it is worth noting that tariff costs—estimated by the Council on Foreign Relations to have been borne 55% to 67% by consumers—will largely be refunded to importers of record. This transfer from consumers to the importers may result in a near-term profit boost for large retailers and some amount of pass-through stimulus for consumers. 

Our last bit of “ugly” forecasting last quarter involved a “sunshine, rainbows, and unicorns” scenario where politicians got together (stay with me) and made the tariffs permanent in exchange for an extension of the Covid-era ACA subsidies. No grand bargain occurred and if anything, the two major political parties seem more diametrically opposed than ever. In a world that is not binary, we may be nearing a point where a simplistic worldview and solution set is inadequate for the severity of the problems we face. Childlike avoidance of existential threats, self-dealing of our representatives, and short-termism are our shortcomings that are truly ugly and a dereliction of our stewardship of this economy. 

Although “good” news seldom garners many headlines, there are many things going well with the U.S. economy. The tensions with Iran caused a pullback in stock market prices, but considering how much impact the region has on global commerce, being roughly 2% to 3% below the record high values for the indexes speaks to the resilience of the U.S. economy. Corporate earnings are projected to grow approximately 17.4% for 2026, partially supported by productivity gains from AI. As stated earlier, the labor environment is also strong by many measures. Real wage growth, although modest, is positive so workers are gaining ground relative to inflation. When people have jobs and their wages allow them to enjoy improved purchasing capacity, the foundation of the economy is currently solid. Further supporting near-term growth of the U.S. economy are the stimulative aspects of President Trump’s One Big Beautiful Bill Act (OBBBA). In addition to business incentives, which Principal estimates will add 0.6% to 1.1% to 2026 GDP, the provisions on tips and overtime are expected to add $50 billion to $80 billion in annual disposable income through 2027. The world may be in flux, but the U.S. economy has many bright spots. 

We already touched on some of the “bad” aspects of the economy, but persistent inflation, unending deficits, and war-related supply chain shocks are the main current challenges. High energy prices function as a regressive tax, disproportionately impacting lower-income households. According to the U.S. Energy Information Administration, each $1 per gallon increase in gasoline prices reduces non-energy consumption by approximately 0.3% to 0.5% of GDP. Given the historical correlation between energy production and global economic output (roughly 0.87 over the past 40 years), sustained disruption could materially dampen growth. The longer the war persists and the more widespread the infrastructure damage, the worse the spillover may impact consumers and economic activity. 

An unexpected negative development might come from a theoretical and technical inflationary influence. Many Fed governors have recently indicated that they are comfortable with current central bank policy rates. It indicates that policymakers believe the Fed Funds Rate is near a neutral position. The neutral rate (also called R*) is the theoretical policy rate that is neither stimulative nor restrictive in its influence on the economy. The illusive R* is important because it is a factor in the Fed’s decisions. Several market-based estimates of R* suggest the current neutral rate ranges from 3.3% to as much as 4.35%. There tends to be a strong relationship between the 2- year Treasury yield and the subsequent change in the Fed Funds Rate. Currently, the 2-year Treasury yield is higher than the effective Fed Funds Rate. It suggests that current policy rates may be stimulative, which could exacerbate inflationary pressures. When considered with declining savings rates, which tend to be inflationary, along with the OBBBA stimulus and the wealth transfer to importers, there is a legitimate chance that inflation may trend even farther from the Fed’s longterm goals. Reasons why the neutral rate may have trended higher include a surge in productivity from AI, the persistence of inflationary pressures, or a decline in the appeal of government bonds. Although the Fed can correct policy, currently they may be positioned to stoke inflation, which is not the expectation of the market. 

Our “Good, Bad, and Ugly” section wouldn’t be complete without diving into private credit. We mentioned private credit as an area of concern in our Q1 2024 edition of Insights. Following the Great Financial Crisis, non-bank financing entities grew at a rapid pace, now totaling $2 trillion in assets. The current situation is a result of an opaque asset class, inappropriately allocated investors, and “Jonny-come-lately” fund managers. The asset class is opaque in that some investors don’t know what they hold, and for that matter, some investment managers may not have much of an idea either. One example is a $1.8 billion loan to Medallia Inc., a software company, where one of the largest private credit managers has the loan value at $0.97 and another major manager priced the loan at $0.77 (so on a $100,000 investment, one manager values it at $97,000 and the other has it at $77,000). There are reports of far more dramatic loan “mark” discrepancies. Part of the issue is the managers themselves report the value to investors. If fees are charged on market value, there may be a conflict of interest that is difficult to avoid. 

Sadly, some private credit investors, both individual and institutional, are accustomed to public markets, where you can get out of an investment almost immediately. Private credit funds have liquidity windows, or limits on the amount of liquidity they must offer investors on a quarterly basis (with 5% per quarter being the most common). If investor demand exceeds a set threshold the fund can impose a gate or suspend redemptions until the market stress subsides. In the first quarter of 2026, investors sought to withdraw approximately $13 billion from a dozen of the largest funds. As a result of the gates being imposed, nearly $5 billion is trapped in the funds. The desire for liquidity isn’t due to a current spike in defaults on the underlying loans. Moody’s estimates that as of January, if you lump actual defaults in with “extend and pray” solutions where struggling borrowers “pay” debt by either extending the amortization of their debt or Payments in Kind (paying off debt with new debt), the default rate on private credit is 5.8%. UBS has one of the most pessimistic estimates on the street, with a belief that defaults on private credit could reach 15% if AI causes an “aggressive” disruption among corporate borrowers. A lot of the loan terms are within eight years, so the headline-grabbing number seems like a remote possibility. We expect that since some investors feel trapped, there will be investment outflow pressure for many quarters, if not years. It should mean depressed returns as some investors work their way through the exits. A positive development should be improved underwriting standards on the part of the managers and stronger loan holder protections (covenants). Near term pain for current investors and longer-term gain for investors for whom the asset class is appropriate. 

Variability in quality of the investment managers is another aspect that needs to get flushed out of the private credit space. Inexperienced managers, without the staff to “work out” distressed loans, have been eager adopters of kicking the can down the road solutions. Some fund-of-funds strategies and fledgling managers in the private credit market have a veneer of talent which results borrowers dictating terms as they are failing, and investors likely taking a back seat to convenience and firm profitability. As investors and managers who may not be a good fit for private investments work their way out of the market, returns may be challenged. In the end, the private credit market should be strengthened and the liquidity windows and gates that are causing panic now may be the differentiator that benefits investors for whom the asset class is appropriate. As the disorder causes credit concerns and firms try to grab headlines, there may be temporary spillover effects into credit spreads in the public debt markets. We are nearly a standard deviation “tight” with investment grade corporate bond spreads, so anything that approaches an “average” spread we see as an opportunity to add credit exposure. 

The market expects GDP to decrease as 2026 progresses, while unemployment rises and inflation moves higher as compared to the first quarter. Concerns about oil prices and the uncertainty of war could suppress economic expectations, causing Treasury yields to temporarily decline. Immovable deficits, supply chain disruptions, and several sources of stimulus have a good chance of carrying Treasury yields higher. We see a floor on the 10-year Treasury of roughly 4% and an upper bound of 4.80% for the remainder of 2026.

This Newsletter is impersonal and does not provide individual advice or recommendations for any specific subscriber, reader or portfolio. This Newsletter is not and should not be construed by any user and/or prospective user as, 1) a solicitation or 2) provision of investment related advice or services tailored to any particular individual’s or entity’s financial situation or investment objective(s). Investment involves substantial risk. Neither the Author, nor Advanced Capital Group, Inc. makes any guarantee or other promise as to any results that may be obtained from using the Newsletter. No reader should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence. To the maximum extent permitted by law, the Author and Advanced Capital Group, Inc., disclaim any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the Newsletter prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. The Newsletter’s commentary, analysis, options, advice and recommendations present the personal and subjective views of the Author and are subject to change at any time without notice. The information provided in this Newsletter is obtained from sources which the Author and Advanced Capital Group, Inc. believe to be reliable. However, neither the Author nor Advanced Capital Group, Inc. has independently verified or otherwise investigated all such information. Neither the Author nor Advanced Capital Group, Inc. guarantee the accuracy or completeness of any such information.