Outlook The U.S. economy continues to demonstrate remarkable resilience. Labor markets remain healthy, consumer spending has held up well, and investment in artificial intelligence infrastructure continues to drive both corporate earnings and broader economic activity. Despite market fears that higher interest rates could significantly slow growth, economic momentum seems to have held up stronger than anticipated through the first half of 2026. This strength raises an important question: Is the Fed’s interest rate policy truly restrictive? While nominal interest rates remain elevated, inflation has also proven more persistent than many expected. As a result, real (inflation-adjusted) interest rates may not be as restrictive as headline policy rates suggest. Further, strong household balance sheets, ongoing fiscal support, and robust business investment seem to give the Federal Reserve some leeway to raise rates, if needed, while keeping the economy moving forward.
. . . Markets Reach Record Highs Before Late Week Reversal U.S. equities began the week on strong footing, extending May’s powerful rally, with the S&P 500, Nasdaq, and Dow all reaching fresh all-time highs to start the new month. The move was initially supported by continued enthusiasm around artificial intelligence (AI) and strong earnings momentum across the technology sector. Gains were broad but remained heavily concentrated in AI-related names, with semiconductor and infrastructure companies leading the advance. Continued capital investment in data centers and AI capabilities reinforced investor confidence, helping the S&P 500 push above the 7,600 level. However, sentiment shifted sharply later in the week following the release of the May employment report, which prompted a reassessment of the interest rate outlook and led to a pullback in equities, particularly within technology stocks. Strong Employment Report Changes the Narrative The May jobs report was the key catalyst for the market’s reversal, coming in significantly stronger than expected and underscoring the ongoing resilience of the U.S. economy.1 - Nonfarm payrolls increased by 172,000, more than double consensus expectations of roughly 85,000
- The unemployment rate held steady at 4.3%, remaining in a narrow range over recent months
- Average hourly earnings rose 3.4% year over year, indicating moderate but still positive wage growth
- Prior months (March and April) were revised higher, adding further strength to the overall labor picture
Job gains were concentrated in sectors such as leisure and hospitality, government, and healthcare, reflecting continued strength in services and government hiring. While the report confirmed that the economy remains on solid footing, it also reinforced a key concern for markets, as economic strength reduces the urgency for the Federal Reserve to ease policy. Inflation Rate Expectations Shift Sharply The stronger-than-expected labor data prompted an immediate repricing of interest rate expectations. Prior to the report, markets had been anticipating potential rate cuts later in 2026 as growth slowed and inflation gradually improved. However, following the release, those expectations shifted meaningfully. Expectations for near-term rate cuts were largely pushed out or removed, and markets began to price in a higher probability of additional rate hikes. The probability of a 25-basis-point increase in interest rates in October rose to 41% from 25% a week ago, or to 43% for a potential December move from 36%, according to the CME FedWatch tool. Treasury Yields Rise as Bonds Reprice The bond market reacted quickly to the shift in expectations, with yields moving higher across the curve. The 10-year Treasury yield rose to approximately 4.55%, while the 2-year yield climbed above 4.15%, reaching its highest level in over a year. This move reflects a broader repricing of the “higher-for-longer” rate environment, as investors adjust to the likelihood that policy will remain restrictive for an extended period. More broadly, Treasury markets in recent weeks have been undergoing a recalibration, incorporating persistent inflation, resilient growth, and evolving Fed policy expectations into higher yields and a potentially higher assumed “neutral” interest rate. Higher yields continue to create a more challenging environment for equity valuations, as rising rates increase the discount rate applied to future earnings, which may place pressure on elevated valuations. Taken together, the week highlights a market that remains fundamentally supported but increasingly sensitive to economic data and shifts in interest-rate expectations. | 
