Budget office expects Federal Reserve to cut rates in 2026

The Congressional Budget Office projects the Federal Reserve will begin cutting short-term rates in 2026 with the policy rate around 3.4% by late 2028, even as the 10-year Treasury yield is forecast to drift up from 4.1% in Q4 2025 to 4.3% in Q4 2028 — implying higher mortgage costs ahead. The CBO sees the unemployment rate peaking at 4.6% in 2026 before easing to 4.4% in 2028, real GDP growth rising to 2.2% in 2026 then averaging 1.8% in 2027-28, and inflation easing to about 2.1% by 2028; projections incorporate effects of tariffs, immigration policy, the 2025 shutdown and recent tax and spending legislation.

Analysis

Market structure: The CBO path (Fed cuts in 2026 to a 3.4% policy rate by 2028 while 10‑yr yields drift up from 4.1% to 4.3% through 2028) implies a mild long‑end repricing and a modest steepening of the curve. Winners: banks and insurers (net interest margins and investment portfolios benefit from a steeper 2s/10s) and residential landlords (higher mortgage rates support rental demand). Losers: homebuilders, mortgage originators and rate‑sensitive consumer durables as mortgage financing becomes ~20–50bps more expensive if 10y approaches 4.3–4.5%.

Risk assessment: Tail risks include a policy surprise—Fed delays or abandons cuts (rates higher into 2026) or inflation re‑acceleration from tariffs pushing 10y >5.0%—both would shock rates, credit spreads and RE markets. Near term (days–months) expect volatility around CPI/Fed speeches; medium (6–18 months) risk is a soft patch as unemployment peaks at 4.6% in 2026; long term (2–5 years) demographic drag (lower immigration) risks structurally slower GDP (<2%) and tighter labor supply.

Trade implications: Favor a steepener (long 10y futures/short 2y futures) targeting a 10–30bp steepening within 3–12 months and a 6–12 month long bias in bank equities (BAC, JPM) sized 1–3% portfolio weight. Short homebuilders (XHB or PHM) and buy put spreads on PHM/DHI for 3–9 months; consider buying call spreads on KRE or BAC to express curve benefit with defined risk. Use options to cap downside: e.g., buy 3–6 month PHM 5–10% OTM put spreads; hedge steepener with breakeven if 2y outperforms by 15–25bps.

Contrarian angles: Consensus may underprice sticky tariff‑driven inflation and the rental demand offset to housing weakness; shorting all REITs is blunt—multifamily REITs (EQR, AVB) could outperform homebuilders. Also, if Fed cuts are delayed, banks’ NIM upside is larger than priced; historical parallel: late‑cycle curve steepening before easing (1995–2000 episodes) produced outsized bank EPS beats. Unintended consequence: higher mortgage costs could lift CRE residential cash flows, so be selective within real estate.

Key Decisions for Investors

• Establish a 2–3% portfolio long in regional bank exposure via KRE ETF and add 1–2% long positions in BAC and JPM (equal weight) with 6–12 month horizon; target +15–25% upside if 2s/10s steepens by 25–50bps; set stop‑loss at -8% absolute.
• Implement a 1.5–2% short position in homebuilders via XHB or outright short of PHM with a 3–9 month horizon; alternatively buy a PHM 3‑month put spread (5–10% OTM) to limit capital at risk; trim if 10‑yr yield falls below 3.9% or PHM underperforms < -12%.
• Enter a Treasury steepener trade (long 10y futures, short 2y futures) sized to risk 0.5–1.0% portfolio volatility, targeting 10–30bps steepening within 3–12 months; cut if the 2s10s flattens by >15bps adverse to entry.
• Add a 1–2% tactical long in multifamily REITs (EQR or AVB) for 12–24 months to capture rental upside from tighter mortgage affordability; take profits if same‑store NOI growth lags by >150bps versus consensus.
• Buy a 3–6 month call spread on KRE or BAC (defined‑risk) to express convexity to NIM expansion while simultaneously buying a cheap long‑dated (9–12 month) put on XHB to asymmetrically protect portfolio downside if housing deteriorates faster than CBO baseline.