Financial Institutions Quarterly Insights 4th Quarter 2026

Q4 Strategy

As the war with Iran continued, oil prices rose from $69 per barrel to more than $100 by quarter-end, contributing to a steady rise in interest rates. It was one of the largest increases in years. The yield on the 2-year Treasury note increased 70 basis points, the 10-year Treasury yield increased 81 basis points, and the 30-year Treasury yield rose 68 basis points. Rising rates are not unique to the United States; yields have moved higher across global markets. As the Fed watched this unfold, it became apparent that tighter monetary policy was needed. The Fed delivered a 25-basis-point rate increase on September 16, raising the target range to 3.75%–4.00%. Policymakers’ September projections indicated that another increase this year was possible, while market pricing favored December. Savers have not seen rates this high in years, but mortgage rates are also rising, creating another affordability challenge for first-time homebuyers.

The third quarter was slightly positive for the equity markets despite rapidly rising interest rates. Equity markets tend to react negatively to rising interest rates. Very strong earnings helped by the AI infrastructure buildout have kept the outlook for corporate earnings very healthy. This is expected to persist for the near future. In addition, the economy has been growing steadily and appears to be gaining momentum currently. The combination of a strong economy and a boost from AI spending have been good for corporate earnings.

The economy continues to grow steadily. GDP increased 2.5% in Q1, 2.2% in Q2, and is expected to grow 3.7% in Q3. The unemployment rate has been falling this year and was 4.2% most recently. Nonfarm payrolls have increased each of the last 6 months but the changes month to month have been quite volatile. Core inflation has been stuck at 3.0% and the Fed is determined to bring it closer to its 2% target. Credit spreads remain very low, indicating credit markets are comfortable with higher rates in general. If we see credit spread increase that will be an early warning sign that something is about to change. Credit spreads widen when fears of a slowing economy lead to an expectation that defaults will increase. Fortunately, spreads have remained very low. Despite decent GDP growth, consumer expectations are near a 50-year low. Affordability is a huge issue for many consumers.

Both the S&P 500 and the NASDAQ have positive returns in the 3rd quarter. The S&P 500 advanced 2.3% and the NASDAQ rose 2.6%. Both are up over 10% for the first 9 months. Earnings remain very strong in the tech sector and the energy sector. Other parts of the equity are struggling. Small caps have been negatively impacted by higher interest rates. Consumer discretionary posted a negative return as did utilities. Financials were lower as well. A handful of companies are doing extremely well (like chip stocks) which masks some of the issues in other sectors. Historically, September is a rough month for equities and the outlook for the 4th quarter is very good.

This interest-rate environment offers attractive opportunities for fixed-income investors. One example is a bond issued by a leading premier A1/A rated banking organization, that matures in four years and yields 5.65%—compelling value for a short-maturity bond. Farther out the curve, a bond issued by a large brokerage firm, rated A2/A-, matures in 2037 and yields 6.30%. With interest rates near their highest levels since 2002, we favor extending maturity rather than remaining concentrated in shorter securities. AA- or AAA-rated bonds maturing in 2046 can yield more than 6%. Opportunities of this quality and yield are unusual, and we find them attractive.

Another sector offering compelling value is government-guaranteed mortgage-backed securities. Consider a 20-year security issued by a major government agency. The bond trades at approximately $95, has an average life of seven years, and yields 5.90%—a spread of 74 basis points. Its duration is 5.3 years. The discount price provides some protection if rates fall and homeowners refinance. A 15-year MBS yields just over 5.5%, has an average life of roughly five years, and a duration in the mid-four-year range. Both offer attractive value, but we prefer the longer option.

Let’s look at a market we haven’t discussed for a very long time. The U.S. Treasury market is one of the most liquid markets in the world. Maturities range from 1 month to 30 years. Yields range from 3.95% for a 1-month maturity to more than 5.50% for a 30-year bond. The 5-year maturity Treasury note trades at 5% and the 10- year Treasury at 5.25%. Yields are the highest since 2002. Each investor chooses what maturity fits best for their own situation, but in this environment a little longer than normal seems prudent.

The economy appears to be gaining momentum. Corporate earnings have been strong and are expected to stay that way. Interest rates are at 25-year highs. Fixed-income investors have an opportunity to invest in yields that are very attractive as rates have risen sharply this year. We believe going with longer maturities is a good strategy. Corporate bonds provide over 6% market yield in many cases and U.S. treasuries can yield well over 5%. It’s a good time to be a fixed-income investor.

Q4 Interest Rate Outlook – Time to Hit the Brakes?

Several themes from last quarter’s Insights subsequently drew market attention. At the start of the year, we argued that the neutral rate was higher than the prevailing federal funds rate, supporting our call for renewed tightening while markets still expected additional cuts. We also questioned whether future AI-related revenue could justify the current pace of capital spending. Our most prominent theme, however, has been crowding out. All three warrant further examination. The Fed has largely validated the view that less-accommodative policy was appropriate. At the same time, policymakers and AI-industry leaders have increasingly called for stronger safety standards. Reports that advanced models can identify software vulnerabilities, behave deceptively, or escape their “sandbox” deserve scrutiny. Critics also argue that some closed-source developers may favor regulations that widen their competitive moat against lower-cost open-source models. Liability standards for misdeeds caused by AI systems may become part of the policy response. The debate will intensify, but political gridlock may make it difficult to balance AI dominance and public safety.

We have discussed crowding out in the debt markets at length, and it has now become a central market concern. The conventional theory holds that elevated government borrowing raises financing costs for corporations and erodes profit margins. We have argued that the relationship may now run in both directions: heavy corporate borrowing, particularly for AI infrastructure, can also increase the government’s funding costs, while persistent deficits and rising debt-service expense add further pressure. This competition for capital is occurring as savings rates decline, and the global savings glut of the prior decade recedes. Some AI-related borrowers may be relatively insensitive to whether financing costs are 5% or 6%. Microsoft, for example, has reported cloud gross margins above 60% and revenue growth approaching 30%. For a business with that growth and profitability, a modest increase in borrowing costs may have limited effect on margins. Most governments have far less flexibility. Their ability to raise revenue or reduce spending is constrained by politics, demographics, and existing commitments. Political polarization makes the challenge more complex by turning the suite of available solutions into a couple of disheveled closets. September was among the weakest months for municipal bonds in nearly four decades. The move did not reflect broad concern about issuer creditworthiness or a major change in tax policy. Municipal yields rose alongside Treasury yields, but heavy new issuance had to be absorbed by an investor base increasingly dominated by households and household-oriented vehicles. Muni issuance totaled approximately $474 billion through September and remained on pace to exceed 2025’s record of $563 billion. The municipal market therefore contributed to the same crowding-out pressure affecting corporate and sovereign borrowers.

The debt challenge is not unique to the United States; several developed economies face persistent deficits and rising debt burdens. France has attracted particular attention. Populist politician Jean-Luc Mélenchon has advocated effectively canceling 18% of the country’s sovereign debt. Such a policy would amount to a default or forced restructuring—not simply monetary financing—and would likely impair market access, widen spreads, and increase inflation and currency risk. Outcomes have varied widely across sovereign restructurings. In the 1990s, several Latin American countries renegotiated their debt; Ecuador later defaulted, after which its sovereign spreads widened sharply and borrowing costs surged. The broader lesson is clear: investors have alternatives, particularly when global savings are scarce, and governments that weaken creditor protections can face materially higher funding costs.

The United States will also need to confront its deficit and debt issues. Gross federal debt exceeded $40 trillion in October, while annual net interest expense is now approximately $1 trillion—roughly 14% of projected 2026 federal outlays. TD Securities projects that interest costs will continue to rise to $1.5 trillion over the coming decade. The debt “snowball” is rolling down the hill and gaining both size and speed. Corporate borrowing this year of more than $445 billion, much of it related to AI infrastructure, adds another source of financing demand. SpaceX, for example, recently announced it is seeking approximately $40 billion to purchase Nvidia processors. At the same time, defined benefit pension demand for long-duration bonds may be changing. Strong equity markets and higher discount rates have improved funded status for many plans, allowing some sponsors to consider termination or reduce the urgency of adding long-duration assets. Open plans may also retain more growth exposure. For the bond market, the implication is that a historically less price-sensitive buyer may absorb fewer long-dated bonds. Issuers may therefore need to offer higher yields to attract a more rate-sensitive buyer base, placing upward pressure on the term premium.

We have previously framed the deficit debate as a question of revenue versus spending. Under CBO’s February 2026 baseline, federal revenue equals 17.5% of GDP, slightly above its 50-year average of 17.3%. Federal outlays equal 23.3% of GDP, compared with a 50-year average of 21.2%. Historical averages do not, by themselves, determine the appropriate size of government, but they clarify where the current imbalance resides. An intelligent public conversation about the sustainable size and scope of government might be both productive and refreshing. The composition of revenue has also shifted: individual income-tax and tariff receipts are elevated, while payroll and corporate-tax receipts are below longer-term norms. IRS data for 2023 show that the top quartile of taxpayers received 68.5% of adjusted gross income and paid 86.3% of federal individual income taxes, while the bottom half received 12.3% of AGI and paid 3.3% of those taxes. Broader measures that include refundable credits, payroll, corporate, and other federal taxes show effective tax rate of -10% while the top 20% of earners had a rate of 17%. The increasing concentration of income-tax payments warrants awareness because it can make federal revenue more sensitive to high-income earnings and asset-market cycles. The top 20% of earners accounted for 70% of tax receipts in 2022, up from 55% in 1979. With Social Security and Medicare facing mounting financing pressure over the next decade, policymakers will ultimately need to address both revenue generation and expense management.

The midterm elections may provide a source of recovery for the bond market. Not because this crop of politicians will compete in the arena of ideas and further the ideal of a shared successful future, but because gridlock remains the most likely outcome. It will probably reduce legislative productivity, but it could also limit the passage of large new spending programs and slow further deterioration in the deficit outlook. Bond investors may view that constraint favorably. A change in congressional control could also alter the administration’s latitude on Iran, although the direction and magnitude of that effect are uncertain. If military activity moderates and oil flows improve, inflation pressure could ease, giving the Fed more room to pause once policy is on the restrictive side of a neutral range. In that scenario, the bond market could recover into year-end. The path will not be linear: geopolitical decisions, supply shocks, and the Fed’s unusually limited forward guidance will continue to create volatility and an elevated information premium.

If that is the upside case, the downside case is defined by concentration and fragility. Last quarter, we cited the Bank for International Settlements on the risk that doubts about returns on AI investment could trigger a pullback in capital spending and financing. A form of concentration Warren Buffet historically highlighted is corporate profits as a share of the economy. In the first quarter of 2026, corporate profits relative to nominal GDP hit an all-time high of 12.1%. This record profit metric was made possible due to the AI spending boom, fiscal stimulus in the form of a 6% budget deficit, and consumer spending sustained partly through lower saving. That combination may not be sustainable. Goldman Sachs estimates that AI-related spending accounts for nearly half of expected earnings growth among S&P 500 companies. Near-term revenue is strong, but depreciation and operating costs may emerge with a lag. If confidence in the economics of the AI buildout weakens, a sharp decline in investment and credit availability could spill into employment, profits, and asset values. Household finances show a similar concentration. The Federal Reserve’s 2025 Survey of Consumer Finances found that median net worth for households headed by someone age 75 or older rose 37% from 2022 to 2025, while median net worth for households under age 35 fell 23%. Across all households, real mean net worth increased 7% to approximately $1.24 million, while median net worth rose only 2% to approximately $216,000. That gap illustrates how asset appreciation has disproportionately benefited wealthier households. Labor-market conditions are mixed: unemployment is 4.2%, and job openings are approximately equal to the number of unemployed workers, yet unemployment among recent college graduates is materially higher than for college graduates overall. Consumers are saving less, younger households are under greater financial strain, and the economy is increasingly exposed to a narrow set of investment and asset-price drivers. That concentration could amplify the damage if AI capital spending or equity markets weaken.

Strategy and Summary – What Just Happened?

Momentum remains on the side of the AI buildout, but the remainder of 2026 is likely to feature uncertain energy markets, heavy borrowing by participants in the AI race, and persistently elevated yields needed to absorb record debt issuance. Consumers face weak real wage growth, elevated debt-service burdens, declining saving rates, and increasing delinquency pressure. The concentration of income, wealth, and tax payments may be sowing the seeds of future economic or social change. Whether the issue is the federal deficit, the AI buildout, or savings funded consumption, the sources of U.S. growth appear to be on an unsustainable path. Near term, rates may stabilize if divided government limits additional fiscal expansion. A more pronounced bond-market recovery is possible if the Iran conflict de-escalates, oil prices decline, and the Fed can stop tightening near a neutral-to-modestly restrictive stance. With bond yields near multi-decade highs and real yields approaching a two-standard-deviation event, gradually adding long-duration exposure while retaining a complementary allocation to money-market or cash-plus strategies remains an attractive risk-adjusted approach.

Our earlier forecast that the 10-year Treasury yield would remain between 4.0% and 4.8% in 2026 needs revision. The yield reached approximately 5.3% during the quarter, and a further escalation in the Iran conflict could push it toward 5.75%. A broader slowdown in AI investment—triggered by doubts about project economics, tighter capital access, and spillovers into employment and corporate profitability—appears more likely to be a 2027 risk. For 2026, flat to negative bond returns remain the most probable outcome; 2027 should begin with a more attractive yield cushion. The municipal market dislocation may prove to have been an appealing entry point once the supply-demand imbalance normalizes. Iran will remain central to both inflation and the bond-market outlook, and the conflict’s range of outcomes remains unusually wide. For investors, the relevant conclusion is that energy supply, fiscal policy, the term premium, and risk spreads will remain tightly linked.

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