Economic overview

Federal Reserve policy: Navigating a shifting labor market

U.S. economic growth in 2026 is likely to be close to 2%, a similar level to 2025, with risk skewed to the upside. The Federal Reserve (Fed) is expected to maintain an easing bias in 2026, with the fed funds lower bound likely moving toward 3.00% – 3.25% and the pace of interest rate cuts expected to slow. The recent FOMC meeting supports this view, with the median rate outlook from the Summary of Economic Projections reflecting additional rate cuts in 2026 and 2027. The Fed is closely monitoring the labor market, which continues to show signs of softening. Non-Farm Payrolls have declined steadily, with the three- and six-month rolling averages now at just 22,000 and 17,000, respectively (Exhibit 1). At the same time, unemployment has increased to a cycle high of 4.6 percent.

Above-target inflation, combined with a weakening labor market, is creating tension between the Fed’s dual mandates and complicating policy decisions. The Fed has signaled that downside risks to employment have increased, suggesting it may prioritize supporting the labor market. We expect the current “low hire, low fire” environment to continue, as companies remain cautious and await more clarity on evolving tariff and fiscal policies. Recent changes in immigration policy should help offset some unemployment risks. For short-term fixed income investors, this environment is likely to be supportive for rates, but it also highlights the need to closely monitor both labor and inflation data.

Fiscal policy, credit markets, and the investment landscape

The One Big Beautiful Bill Act is set to provide a short-term boost to consumers. Reduced tariff uncertainty should further support business sentiment and encourage investment. The combination of looser monetary and fiscal policy is broadly positive for risk assets, creating a constructive environment for investors. Investment-grade corporate issuance is expected to reach record levels (Exhibit 2) due to merger and acquisition activity accelerating, which reflects increased confidence among businesses. With credit spreads near historical tights, the generally positive macroeconomic backdrop should help prevent significant widening.

Despite these opportunities, several risks remain. The risk of another government shutdown could temporarily cloud economic data and weigh on growth. The current environment is marked by a K-shaped economy, where upper income cohorts benefit from wealth effects and rising asset values, while lower income households continue to struggle with inflation and affordability challenges. This divergence is likely to persist, reinforcing disparities in consumer experiences and spending power. Although the macro backdrop is supportive, a modest deterioration in credit fundamentals may occur as issuance and deal activity increase. Concerns about an artificial intelligence (AI)-driven equity bubble and risks in private credit could persist, though these are likely to remain concentrated in specific sectors. Continued vigilance is warranted and regular reassessment of portfolio exposures may be prudent as these risks evolve.

Funding markets, liquidity dynamics and opportunity

Funding market liquidity will remain a central focus in early 2026, with money market funds providing reliable liquidity and positioned to benefit from elevated overnight rates and sustained demand for short-term funding. The Fed’s decision to end quantitative tightening (QT) indicates that system reserves have shifted from “abundant” to “ample,” reflecting increased demand for liquidity (Exhibit 3). While ending QT temporarily halted the reserve drain, the underlying dynamic remains a tighter balance sheet, which has resulted in repo rates persistently trading toward the upper end of the Fed’s target range. Episodic volatility around key dates such as month-ends, quarter-ends, Treasury settlements, and corporate tax dates led to even larger spikes and occasionally pushed rates above the Interest on Reserve Balances (IORB) and the upper bound of the Fed’s target range.

In an effort to avoid repeating the funding market challenges experienced in the fall of 2019, and in recognition of a tighter reserve environment, the Fed has initiated reserve management purchases (RMPs) to expand its balance sheet and help address the elevated repo rates observed in recent months. While we did see year-end pressures materialize, with the Secured Overnight Financing Rate (SOFR) challenging or briefly surpassing the upper bound of the target range, we expect that episodes of repo rates above IORB will diminish as we move into 2026, ushering in a period of more stable, range-bound repo rates in the new year.

Investment strategy

In this environment, several investment implications are relevant for cash investors:

Duration management: While the FOMC continues to signal an easing bias, we may be nearing the end of this rate-cutting cycle. In this context, active duration management is essential, and it’s important to remain nimble. We favor selectively extending duration at the short end to secure attractive cash yields, while preserving flexibility to adjust duration as policy signals and curve dynamics evolve. We will continue to apply this approach in our product offerings to maintain and protect yield. Investors can likewise optimize duration by pairing ultra‑short fixed income with daily liquidity vehicles like money market funds (MMFs), adding or trimming exposure as conditions change.

Diversification and liquidity

For corporate treasurers managing short‑term cash, diversified exposure across sectors and high‑quality ratings can enhance stability and liquidity. With valuations relatively tight for investment grade credit and with investors watching for potential knock‑on effects from elevated AI‑related capital expenditures and private credit, selectivity and price discipline are key.

Investors should consider investment policies that allow measured flexibility across sectors and rating buckets within their risk appetite and maintain ample liquidity buffers. Pair money market funds for daily liquidity and principal stability with ultra‑short fixed income portfolios that seek incremental yield and potential capital gains. Our primary focus remains on liquidity and principal preservation, with the ability to nimbly allocate as market dynamics change.

Conclusion

We believe 2026 presents a favorable environment for money market and ultra-short income investors. Supportive monetary and fiscal policies, resilient labor and credit markets, and ample system liquidity should underpin attractive yields and stability. With these factors in place, investors can look to money market and ultra-short income funds for consistent performance and effective capital preservation. Although some uncertainty remains, these asset classes are well positioned to deliver value and security.