Will the Federal Reserve cut interest rates in 2026?

The FOMC voted 11-1 to hold the federal funds rate at 3.50%-3.75% and the SEP median projects one 25bp cut this year and one 25bp cut in 2027 with year-end funds rate medians of 3.4% (this year) and 3.1% (next year). The Fed revised PCE inflation to 2.7% at year-end (core PCE 2.7%), up from 2.4%/2.5% in December, and Chair Powell said progress on inflation will be slower than hoped, tied in part to tariffs and the Iran conflict. Markets pulled back June-cut expectations sharply: CME FedWatch now shows an 89.2% probability rates remain unchanged after the June meeting and a 51.3% chance they remain at current levels after December, with odds of two cuts this year falling materially.

Analysis

The Fed’s message that cuts are conditional and slower than markets priced removes an easy policy-driven re-risking path for risk assets and keeps short-term rates priced higher for longer; that increases the carry advantage of cash/short-duration instruments and compresses duration risk premium on long bonds. With markets moving from ~60% to ~10%+ probability of a June cut inside four weeks, positioning flows that had been long duration and long cyclicals will need to be reduced — expect mechanical rotation into short-term cash, money-market funds, and floating-rate instruments over the next 2–8 weeks.

Geopolitical uncertainty (Iran) and tariff dynamics are now the marginal drivers of core inflation expectations; if tariff pass-through recedes mid-year as Powell suggested, goods inflation could cool and reopen the path to cuts, but that outcome is both delayed and binary — a tariff shock reversal would lower PCE by ~20–40bp over 3–6 months whereas an escalation in Middle East risk could add 30–80bp via energy and risk-premium channels within weeks. That asymmetry favors trades that monetize near-term policy inertia while preserving upside to a disinflation pivot: short front-end exposure with a structured, convex long-duration hedge.

Second-order winners are cash-rich banks and short-duration credit issuers (CDS cheapens) that benefit from sustained higher short rates; losers are rate-sensitive long-duration growth and mortgage-facing REITs if the Fed delays cuts through year-end. Liquidity and positioning are key catalysts — a sharp repricing of cut odds back toward December-style expectations would be a multi-week squeeze for short-duration shorts and long-duration longs; conversely, geopolitical escalation (30–90 days) would steepen term premia and tighten financial conditions, pressuring equity multiples by 10–20% in stressed scenarios.

Key Decisions for Investors

• Long short-term cash & floating-rate: allocate to SOFR/3M LIBOR floating-rate funds or buy ETF FLRN (avg life ~1.2y) over the next 0–3 months to capture 3.5%+ carry while avoiding duration; target 200–300bp outperformance vs TLT on a 0–12 month horizon if cuts are delayed.
• Pair trade (months): short TLT (or buy inverse TLT) and hedge with OTM long-dated TLT calls (12–18 month expiries) — size 1:0.25. This captures carry and expected curve steepening if cuts are delayed, while preserving asymmetric upside (~4–6x payoff on calls) if a disinflation pivot forces rapid cuts.
• Bank overweight vs mortgage REITs: overweight JPM/BAC (12–24 months) for NIM resilience and deposit repricing benefits; short mortgage REITs like REM or VNQ exposure to residential REIT segments (6–12 months) where refinancing and cap rates will be pressured if rates stay elevated. Risk: a sudden growth slowdown compresses loan demand and can reverse bank strength within 3–6 months.
• Macro FX/EM defensive: go long USD via UUP and hedge EM FX/credit exposure (short EEM or EM local FX futures) for a 3–9 month trade — market-implied probability of cuts has fallen enough that USD upside from higher-for-longer short rates is underpriced. Tail risk: if tariffs/commodity disinflation materializes mid-year, unwind quickly as USD could weaken and EM assets rally.