Allianz Investment Management LLC 2026 Q2 Market Outlook

We maintain our 2026 real GDP growth forecast at 2.0% to 2.5%, unchanged from last quarter but with materially higher uncertainty around the lower-bound estimate. The energy shock and associated financial tightening have raised recession probability. However, the ceasefire, if sustained, should prevent the most severe downside scenarios. The primary risk is that energy price pass-through erodes consumer purchasing power faster through higher gasoline prices than labor income growth can offset, particularly for middle-income households already facing elevated living costs. Upside risk stems from pent-up demand release if geopolitical tensions ease durably and confidence recovers. The “jobless boom” dynamic observed in late 2025, which is characterized by solid GDP growth with minimal employment gains, complicates the outlook, as it suggests elevated productivity gains may be masking underlying demand weakness.

We expect the Federal Reserve to remain on hold for most of 2026, with our target policy rate finishing the year between 3.50% and 4.00%. The ceasefire has created an asymmetric policy calculus: It removes the most compelling argument for cuts, while leaving inflation pressures largely intact. Core PCE is expected to track well above the 2% target, as uncertainty remains around energy pass-through effects. Some Fed members have indicated that rate hikes remain possible if inflation persists, but Chairman Powell downplayed the potential for hikes in recent comments. Markets now price some probability of at least one cut by December, but given the uncertainty, we expect continued volatility around that view. The primary downside risk is that recession materializes faster than inflation moderates, forcing the Fed into reactive easing. Persistent inflation leads to upside risks and a potential Fed hike, but that appears less likely at this juncture.

We anticipate core PCE inflation to finish 2026 in a range of 2.5% to 3.0%, with current tracking data suggesting it could be near the top end of that range. The energy shock from the Iran conflict has created both direct and indirect inflationary pressures that will persist even as oil prices retreat from recent peaks. New York Fed President Williams noted that while headline inflation will rise due to energy costs, his outlook for underlying price pressures remains “largely unchanged.” The key risk is whether energy passthrough into core goods and services proves more persistent than anticipated, particularly if supply chain disruptions from the Strait of Hormuz closure create lasting bottlenecks. Downside risk to inflation stems from demand destruction if a recession materializes, while upside risk comes from wage-price spirals if labor markets remain tight despite slowing employment growth. The Fed’s tolerance for above-target inflation appears limited, constraining policy flexibility.

We maintain our year-end 2026 forecast for the 10-year Treasury yield at 4.00% to 4.50%, with the current level of 4.27% sitting comfortably within this range. The ceasefire triggered a sharp rally from the March peak of 4.43%, but bond traders remain cautious about pricing aggressive Fed easing given persistent inflation. The yield curve has flattened since the beginning of the year as inflation uncertainty has become the ballast for higher rates in the front-end of the curve. Primary downside risk to yields stems from recession materializing and forcing the Fed into aggressive cuts, potentially driving the 10-year below 4.00%. Upside risk comes from inflation persistence requiring the Fed to maintain restrictive policy longer than markets anticipate, or from term premium expansion if fiscal concerns resurface. The balance of risks has shifted more neutral following the ceasefire, but volatility is likely to remain elevated as implementation details emerge.