Photo credit: Milles Team Worldwide

U.S. equities posted a modest advance during the holiday-shortened trading week despite a Wednesday sell-off following a more hawkish than expected Federal Reserve meeting under its new chair, Kevin Warsh. The Fed committed to “unambiguously and unanimously” returning inflation to 2 percent. At this meeting, nine of the 18 members indicated they expected at least one rate increase in 2026, a notable shift from March, when no members projected a hike and multiple participants expected rate cuts.

This change was driven by an upward revision to the Fed’s inflation outlook. Core Personal Consumption Expenditures (PCE) inflation is now expected to reach 3.3 percent at year-end 2026, up from the prior estimate of 2.7 percent, while the 2027 forecast increased to 2.5 percent from 2.2 percent. Offsetting this more hawkish signal—and likely helping to support equity markets—was the signing of a memorandum of understanding between the United States and Iran. The agreement allows oil to flow through the Strait of Hormuz, which could help ease inflationary pressures and, in turn, interest rates.

Taken together, these dynamics underscore the delicate balance facing the U.S. economy and the narrow path the Fed is attempting to navigate. This is a late-cycle environment, yet it’s one shaped by an ongoing artificial intelligence (AI)-driven investment boom that has likely extended the economic cycle beyond what would otherwise have occurred. That dynamic has also exposed the limitations of many traditional economic indicators, which have struggled to fully capture the impact of what has, until recently, been a largely interest rate-insensitive AI expansion.

This challenge is evident in this week’s release of the Leading Economic Index (LEI), which is designed to signal peaks and troughs in the U.S. economy and provide an early indication of significant turning points in the business cycle. Historically, the LEI has provided valuable insight into the future direction of the economy, particularly because it tends to reflect interest rate-sensitive sectors. Since the Fed began raising rates in March 2022—pushing yields higher across the curve through year-end 2025—the index had been negative month over month 41 times and unchanged three times. In other words, it was negative or flat in 44 of 46 readings and advanced only twice. Over that period, it consistently pointed to weak growth and, at times, signaled elevated recession risk—most notably from late 2022 through early 2024 and again from May to September 2025.

That makes the 2026 data notable. Three of the first five readings have been positive, lifting the six-month annualized rate to -0.6 percent. While still negative—and indicative of slightly slower future growth—it is meaningfully improved and remains well above the historical recession signal of -4.3 percent. It is also the strongest reading since April 2022, the last time the index was positive. Importantly, the improvement is not isolated. The six-month diffusion index stands at 70, indicating that seven of the 10 components are positive. While slightly below last month’s reading of 80—the highest since December 2021—it still reflects a potential broadening in underlying growth.

In our view, this highlights an important distinction in the current cycle. Higher rates—conditions that historically would have been sufficient to push the economy into recession—have not had that effect this time. A key reason has been the resilience of AI-related spending, which has remained relatively insulated from higher borrowing costs. At the same time, higher-income consumers have been supported by rising equity markets and limited exposure to variable-rate debt, given the prevalence of fixed-rate mortgages.

Encouragingly, conditions have begun to improve, likely aided by the decline in rates in late 2025 and early 2026 following the Fed’s 0.75 percent rate cuts. Even so, we are once again approaching a critical juncture. The key questions center on the path of rates in the face of still elevated inflation, the potential for additional Fed tightening, and how the Iran-U.S. situation evolves over the next 60 days.

That timing is important because we believe the nature of AI investment is also changing. What was once funded largely through free cash flow by hyperscalers is increasingly being financed through debt and equity issuance, making it more sensitive to interest rates. Evidence of this shift emerged last week, including NVIDIA’s decision to issue $25 billion in bonds. While capital markets remain open and funding is still available, that dynamic could change if financial conditions tighten further in response to any future Fed action.

Against this backdrop, inflation remains the most critical variable. Its importance was reinforced by the Fed’s post-meeting statement, which focused solely on restoring price stability, with no mention of maximum employment. During the press conference, Chair Warsh reinforced that commitment, emphasizing the need to bring inflation back down to the 2 percent target after more than five years of failing to meet that objective. While part of that messaging likely reflects a desire to establish credibility and independence, it is important to recognize that this was only one meeting, no rate hike was implemented, and the committee remains divided.

Markets, for their part, reacted modestly. Prior to the meeting, one rate hike had been priced in. The first hike is now expected by the October meeting, with a second fully priced in by March 2027. While Fed tightening has historically preceded economic contractions, this level of expected policy tightening does not appear sufficient, on its own, to derail the economy—though it does incrementally raise the risk.

That risk is beginning to show up in the bond market. The Treasury yield curve flattened over the week, a development that has historically preceded inversion and often signals rising concern about policy becoming too restrictive. Specifically, the spread between the 10-year and two-year Treasury yields narrowed to 0.27 percent (27 basis points) as the two-year yield rose 9.8 basis points to 4.18 percent, while the 10-year yield declined 2.6 basis points to 4.455 percent.

For context, this spread had widened to 0.73 percent in early February, reflecting improving growth expectations. Its narrowing from 0.40 percent to 0.27 percent is not yet an inversion, but it does suggest growing concern that the Fed may ultimately be forced to overtighten.

This brings us back to the central question: What happens in the next 60 days? If inflation remains persistent, will the Fed need to deliver additional rate hikes and risk overtightening to meet its commitment? Or will it tolerate inflation above its 2 percent target after missing that mark since February 2021? At the same time, tariffs—likely to rise again in the coming months—add another layer of uncertainty to the inflation outlook.

While these questions remain unresolved, the direction of markets continues to evolve. We believe the broadening that began in 2025—when international markets provided leadership—remains intact. This year, that trend has extended within the U.S., with both Small- and Mid-Cap stocks outperforming Large Caps.

This does not diminish the role of Large-Cap stocks, which remain the largest allocation in a diversified portfolio. However, it reinforces the importance of avoiding concentration. Year to date, U.S. Large-Cap stocks are up 10 percent, while Mid- and Small-Cap stocks have gained 15 percent and 20 percent, respectively. International developed and emerging markets, along with U.S. REITs and commodities, have also delivered stronger returns.

In our view, diversification remains critical—not only as a tool for managing risk but also as a source of potential return enhancement. Stay invested, stay diversified, and stay focused on your intermediate- to long-term plan.

About the Author:

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.