USD Bond 2H26 Outlook: Lock in Elevated Yields Amid Persistent Inflation and Flattening Curve

Looking back at the first half of 2026, the U.S. labor market has traced a mixed path rather than cooling in a straight line. Momentum softened early in the year, with nonfarm payrolls briefly turning negative in February. Momentum then rebounded, with monthly job gains of 170,000–210,000 from March to May. The average monthly gain over the first five months stood at approximately 114,000, indicating continued moderate expansion (see Chart 1). Job creation was concentrated in education and health services, leisure and hospitality, and government, while financial activities and information sectors recorded contraction in multiple months.

Chart 1: U.S. Nonfarm Payroll

Entering June, signs of underlying weakness began to surface. Nonfarm payrolls rose by only 57,000—well below the market consensus of 113,000 and the lowest print in four months. In addition, the prior two months’ figures were revised lower by a combined 74,000, suggesting that earlier strength had been overstated. Notably, the unemployment rate edged down to 4.2%. The decline, however, reflected roughly half a million workers exiting the labor force — pushing participation down to 61.5%, its lowest since March 2021 — rather than genuine job creation (see Chart 2).

Chart 2: U.S. Unemployment Rate and Labor Force Participation Rate

Moreover, recent hiring strength in leisure and hospitality has been supported by the temporary boost from the World Cup; stripping out this one-off factor suggests that first-half labor-market resilience may have been exaggerated and that underlying momentum is less robust than surface data imply. Nonetheless, headline numbers remain constructive and are not yet sufficient to prompt a material shift in the Fed’s stance. We expect the Committee will require further confirmation that soft spots are persistent before adjusting its policy posture.

Sticky Services Inflation Keeps Price Pressures Well Above the 2% Target

On the inflation front, core measures continued to rise from March through May. In May, core CPI and core PCE reached 2.85% and 3.41%, respectively—both significantly above the Federal Reserve’s 2% policy objective. The reacceleration in services inflation after March has been the primary driver, while goods inflation has continued to cool and has not exhibited the strength seen in the second half of 2025 (see Chart 3).

Chart 3: U.S. Core CPI       

Within services, elevated housing inflation and the renewed upward momentum in *supercore service (particularly medical care and transportation services) have been the key contributors keeping overall inflation sticky. Housing inflation accounts for roughly 44% of the core CPI basket; after bottoming in February, it rebounded to approximately 3.4% in May—displaying greater stickiness than market expectations and even exceeding levels seen at the end of 2025. This has established a high “floor” for overall inflation.

*Supercore service refers to core services inflation excluding food, energy, and housing services (rent/owners' equivalent rent)

However, the latest June core CPI showed a year-over-year decline — easing from 2.85% in May to 2.59% — with most services components softening apart from housing, indicating some cooling in supercore services. That said, we believe the persistence of this moderation has yet to be confirmed: core inflation remains above the 2% target, and this is only a single month of data. More importantly, Chair Warsh has made clear that it is too early to declare victory, signalling that the Fed will not shift its stance based on one data point. Meanwhile, oil prices have rebounded as cracks have re-emerged in the U.S.–Iran ceasefire, suggesting that inflationary pressures are far from fully resolved.

Meanwhile, supercore CPI accelerated from around 2.7% at the start of the year to approximately 3.7% in May (see Chart 4). Although transportation services—driven in part by oil-price-related airfares—account for much of the rise, medical care as well as education and communication services (which are less sensitive to energy shocks) have also shown clear upward trends over the past two months.

Chart 4: U.S. Supercore CPI

In summary, even after stripping out energy effects, non-energy-related housing and medical-care services inflation continues to exhibit strong stickiness. Against a still-uncertain oil-price backdrop, we believe inflation will remain persistently above the Federal Reserve’s 2% target. The Fed will therefore continue to prioritize inflation control over concerns about labor-market cooling, making further rate hikes distinctly more likely.

The Fed Turns Hawkish

At its June FOMC meeting, the Federal Reserve left the policy rate unchanged in the 3.50%–3.75% target range. However, the post-meeting Summary of Economic Projections (dot plot) showed the median year-end 2026 funds rate rising from 3.4% to 3.8%. Nine of the 18 participants project the year-end rate above the current level. This upward revision was driven primarily by heightened inflation concerns: the median core PCE projection for 2026 was raised from 2.7% to 3.3%. The Committee does not anticipate a sharp deterioration in the economy or labor market, an unmistakably hawkish shift (see Chart 5).

Chart 5: FOMC Participants’ Projections for the 2026 Federal Funds Rate

In parallel, newly appointed Chair Kevin Warsh has substantially shortened the post-meeting statement and formally eliminated forward guidance. This implies that both the Fed and market participants will react more directly to incoming data without being constrained by prior communications. Consequently, policy uncertainty and bond-price volatility are likely to increase.

Yield Curve Flattening

With the Fed removing any dovish bias and adopting a more hawkish stance, the market has progressively priced in additional rate hikes. Short-dated Treasury yields (1–3 years) are more sensitive to monetary-policy expectations than longer-dated yields and have therefore risen more sharply. As a result, the 2s10s spread has compressed to 27 basis points—the tightest level of the year—underscoring the overall flattening of the yield curve (see Chart 6).

Chart 6: U.S. Treasury 2-Year / 10-Year Spread

Duration Positioning: Lock in Elevated Yields; Focus on Intermediate-to-Short Maturities

Under a flattening curve, extending duration no longer delivers sufficient roll-down return or term premium. Intermediate-to-short-maturity bonds therefore represent the more rational choice (see Chart 7). Within this segment, 1- to 2-year Treasury yields currently stand at their highest levels since April 2025. Short duration cushions price declines even through multiple hikes: maturing principal can be rolled into higher yields if rates continue to rise. The 5- to 7-year sector, meanwhile, locks in elevated yields for a longer period and will continue to deliver attractive coupon income should policy eventually turn more accommodative.

Chart 7: U.S. Treasury Yield Curve

Longer-dated bonds, by contrast, should be viewed through a strategic-trading lens rather than as buy-and-hold holdings. Even modest yield moves produce large price swings; in an environment still skewed toward upside rate risk, such volatility sits poorly with buy-and-hold investors. Two forces in particular weigh on the long end: first, should inflation remain sticky and the Fed continue hiking, the entire curve will reprice higher, with longer duration amplifying price losses; second, Chair Warsh has signaled an intention to reduce the size of the balance sheet and potentially sell intermediate- and long-term Treasuries, which would increase supply and push term premiums higher. Investors contemplating long-duration exposure should therefore approach the sector as tactical trades, establishing clear entry and exit levels in advance.

Maintain Preference for Investment-Grade Corporate Bonds

In the corporate credit space, investment-grade credit spreads remain near historical tights. Nevertheless, absolute yields of approximately 5.3% are still well above the 15-year average of roughly 3.2%, offering an attractive opportunity to lock in elevated coupons. High-yield bonds, by comparison, offer a spread over investment-grade of only about 193 basis points—well below the 15-year average of approximately 300 basis points.

Chart 8: U.S. Investment-Grade Credit Spreads

Furthermore, Standard & Poor’s rating data show that the high-yield upgrade-to-downgrade ratio has declined below 1.0 (more downgrades than upgrades), indicating deteriorating overall credit quality. Investment-grade bonds, by contrast, continue to display a robust upgrade-to-downgrade ratio. With high-yield spreads already compressed and credit quality simultaneously weakening, the risk-reward trade-off for high-yield investors has become increasingly asymmetric. Defensive investment-grade bonds therefore remain the more attractive allocation.

Table 1: Standard & Poor’s Upgrade-to-Downgrade Ratios

On the credit side, we maintain our preference for investment-grade bonds. Their current absolute yield of approximately 5.3% remains well above historical averages and presents a rare window to secure high coupons. High-yield spreads over investment-grade of only about 193 basis points offer insufficient compensation, while the deteriorating upgrade-to-downgrade ratio signals weakening credit quality and an increasingly asymmetric risk-reward profile. For investors seeking stable income, investment-grade bonds continue to represent the more rational choice.

Investors may consider selected funds that meet the above criteria, such as the "BlackRock Global Funds – US Dollar Short Duration Bond Fund (USD) A3 Mdis". Investors may also refer to the following list of corporate bonds to receive steady coupon income (see Table 2).

Table 2: Corporate Bond List

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds positions in XYZ 6.500% 15May2032 Corp (USD) and VALEBZ 3.750% 08Jul2030 Corp (USD). The analyst who produced this report holds NIL positions in the abovementioned securities. This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.