Will the Real Yield Please Stand Up?!

by Christian Galipeau of Franklin Templeton, 10/6/26

Macro

Our real gross domestic product (GDP) forecast for 2026 is 2.5% (based on our Global Investment Management Survey) versus the Federal Reserve’s (Fed's) forecast of 2.2% and the Wall Street consensus of around 2%. Last week the final revision for the second quarter came in at a 2.2% annualized growth rate, vs. expectations of a 1.5% annualized growth rate. The economy remains resilient. I’m not a big fan of the Atlanta Fed GDPNow (“nowcasting” model), but note its forecast for the third quarter is 3.73% (as of October 1). The only thing that could throw us a curveball would be a significant policy shift by the Fed; meaning, it signals the beginning of a prolonged rate-hike cycle. It’s hard to “signal” when forward guidance is not a thing anymore. More on what rate hikes mean for equities and fixed income below.
On the inflation front, the core Personal Consumption Expenditures (PCE) price index year-over-year (Y/Y) was 3.0% for August, vs. expectations of 3.3%. July’s number was also revised lower, from 3.3% to 3.0%. Looking at the monthly core PCE price index, August was 0.2% vs. 0.3% expected and, again, the prior data was revised down, from 0.2% to 0.1%. Changes in the calculation seem to be the driver of weaker numbers vs. expectations.
The Institute for Supply Management (ISM) September manufacturing number was 54.5, vs. expectations of 54.7. A reading over 50 indicates economic expansion. The ISM Prices Paid Index (representing input costs across major commodities) was 77.9, vs. expectations of 73, and the ISM New Orders Index number was 55.3, vs. expectations of 54.
The 2-year note yield is currently 4.88%, roughly 88 basis points (bps) over the fed funds rate. Remember, the bond market leads the Fed, not the other way around (as we just saw). Two-year yields continue to call for additional rate hikes. We expect one additional rate hike this year. The US 10-year bond yield is currently 5.30%, and the 2-10s curve has bear steepened significantly to 41 bps, as of this writing, up from 21 bps on September 23.
Breakeven rates have moved higher, especially the one- and two-year measures. One-year breakeven rates are 2.70%, 2-year breakeven rates are 2.50% and 5-year breakeven rates are 2.37%. These numbers represent the bond markets’ pricing of annualized inflation out one, two, and five years. Breakeven rates and the 2-year note are now giving the same message: Something needs to be done to address inflation. The bond market is telling the Fed to raise rates again.
Real yields have moved higher, a reflection of a strong economy. Real yields are calculated by subtracting the breakeven rate from the nominal rate. For example, US 10-year yields are 5.30% and the 10-year breakeven rate is 2.37% (5.30% - 2.37% = 2.93%). This is the highest level for real yields since 2008. Real yields are driving 10-year nominal yields higher, not so much inflation. I would argue that’s a good thing.
Meanwhile, the fed funds futures market is indicating a 37% chance of a 25-bps hike at the October Fed meeting (basically cut in half from last week’s odds) and an 81% chance of a hike in December. The futures market has the 2026 terminal fed funds rate at 4.23%—it believes another hike is coming. We agree and it looks like December.
On the currency front, we are expecting the US dollar to be essentially flat for the year despite the recent volatility. The US Dollar Index (DXY) is trading at 101, still firmly range-bound as it has been for the past 17 months, but is testing the upper end of that range now. I would note that the DXY has been a consensus short for the last few years.

See more: Stock Market’s Wall of Worry Gets Taller

Equities

We are constructive on US equities and have established a year-end target range of 7400-7800 for the S&P 500, driven by 15+% year-over-year (Y/Y) earnings-per-share growth. We are in a catalyst void right now as we await third-quarter earnings. Consensus expectations for 2026 now sit at $366.31, up 12% Y/Y. For 2027, the consensus earnings estimate is $417.49, representing a 14% Y/Y growth rate versus 2026. Estimates have moved up every single week since January 1, which explains the resilience of the tape in the face of higher oil and higher bond yields. (See our Global Investment Management Survey for more on earnings and our forecasts.)
If we assume the consensus earnings estimates are reasonably correct, that puts the tape at 21x this year’s earnings and 18x 2027 estimates. The long-term historical forward multiple is about 17x. Portfolio managers are now focusing their efforts on corporate earnings power for calendar year 2027. I can’t make a strong argument that the tape is “cheap” here, but I also can’t make the argument that an 18x forward multiple is rich either. Bond yields are the biggest risk here. Higher yields will likely put pressure on the multiple at some point.
Sector earnings power is strong. Using FactSet data for earnings growth in 2026, we observe energy leading with 94% Y/Y earnings growth, followed by tech at 57%, communication services at 49%, consumer discretionary at 35% and financials at 15%. That is the top five, and all sectors have positive earnings growth in 2026. Looking forward to 2027 earnings growth, tech leads at 41%, followed by health care at 22%, industrials at 16%, financials at 9% and utilities at 9%.
We are in the “volatility window.” A combination of higher oil prices, higher 10-year bond yields globally, seasonality, midterm elections and a big move on the books from the March lows to the August highs (23.74% for the S&P 500) and concerns about artificial intelligence are conspiring to create a higher volatility level in the near term. Equity implied volatility, as measured by the Cboe VIX index, remains subdued. The duck is calm on the surface (the S&P 500 is less than 2% from its all-time high), yet the duck’s feet are paddling like crazy.
Violent rotation and significant dispersion have been the hallmarks of the tape all year. As of the September 30 close, 34% of the S&P 500 Index components are outperforming the index, while 66% are underperforming. Moreover, 230 names, or 46% of S&P 500 components, are down YTD. Do you have a strategy to create tax alpha by harvesting losses on an ongoing basis? I think the environment is prime time to consider that approach.
What does history tell us about the stock market when the Fed raises rates? Our Strategist Taylor Topousis has done some research on this. Here are the key takeaways: From 1994, when the Fed began to announce policy decisions, median S&P 500 returns three months from the initial hike were -3.7%. Every hiking cycle since 1994 has had a drawdown of at least 7%. This fits with our call for volatility. A year later median returns for the S&P 500 were +6.5%. The Russell 1000 Growth and Russell 1000 Value Indexes were tied at 4.5% each and the Russell 2000 Index leads all players at +12.7%. The MSCI EAFE was positive out one year at +5.2%. The MSCI EM Index was also positive out one year at 1.8%.
Additionally, please see our latest white paper on what to expect from equities in the intermediate term. Market Strategist Lukasz Kalwak and I provide a look at seasonal volatility, midterm election years, liquidity, fundamentals and what we historically see in the third year of a presidential cycle. Don’t miss this piece: “Broadening Delivered. Now Prepare for Volatility.”
Bottom line: We think it’s prudent to have a diversified equity playbook that includes US large-, mid- and small-cap exposure with a balance of growth and value. The same can be said for ex-US equity exposure; emerging markets and Japanese stocks look attractive. That involves reducing concentration and spreading one’s bets. We think buying on pullbacks makes sense. Volatility is your friend.

Fixed Income

We expect 10-year US Treasury bonds to yield in the range of 5.0%–5.5% for the year. As of this writing, the last trade was 5.27%. We have shifted our range higher. Franklin Templeton Fixed Income CIO Sonal Desai is of the mind that we are in a higher-for-longer yield regime. When Sonal talks, I listen. Have a game plan to use higher yields to your advantage. Current yield levels generally approximate the forward five-year annualized return stream. The risk/reward is improving with higher yields. We believe a dollar-cost-averaging approach makes sense on ugly days (higher yields).
The earnings yield calculation is one way to assess the relative valuation between stocks and bonds. The calculation is essentially the inverse of the P/E calculation. For example, S&P 500 earnings are $366.31. The S&P 500 closed at 7,651.54 on September 30, so the calculation is (366.31/7,651.54)*100 = 4.79%. The US 10-year yields is at 5.28%. Are bonds more attractive than stocks here? Marginally, yes.
Implied Treasury volatility is high. The ICE Bank of America MOVE Index is a proxy for fixed income volatility. When rate vol spikes, it can really spike. And when it does, the median MOVE reading back to 2020 is 140. The last trade was 110 vs. an average rate of 85. So if history is any guide, interest-rate volatility could continue to push higher. It is unsettling to markets when one of the most liquid markets in the world gets violent. Things break. Model assumptions fail. Possible forced liquidation can come into play.
Using data going back to 1994, our Senior Analyst Lukasz Labedzki tells us that when the Fed raises rates, US 10-year bond yields moved higher by 15 basis points a year out. US 2-year yields moved higher at the median by 80 basis points a year out and the 2-10s curve flattened by a median of 87 bps a year out. We are seeing history repeat, right now.
We expect short duration fixed income mandates and corporate credit to outperform cash again this year. The short duration call has been working; corporate investment-grade credit—not so much. Rather, all-in yield capture seems to be the play. To that end, investors might consider high-yield exposure to boost total return as a barbell with duration exposure and core bond exposure. High-yield is the only subsector of fixed income where the coupon is significantly higher than duration risk.
I mentioned tax-loss harvesting in equities. Investors can do the same thing in their fixed income sleeves. In non-qualified accounts, one can consider taking the loss and reposition with a new cost basis and a higher starting yield. Get rid of the red.
Credit spreads remain well behaved in the face of higher yields. Investment-grade spreads, as proxied by the Bloomberg US Corporate 1-3 Year Option-Adjusted Spread (OAS), are now 51 bps over comparable Treasuries, 7 bps higher from September 21. High-yield spreads, as proxied by the Bloomberg US Corporate HY OAS, are now 311 bps over, out 47 bps from September 21. These are both relatively tight levels from a historical perspective, reflecting a strong fundamental backdrop with corporate profitability being the main driver.
We are bullish on municipal bonds and find taxable-equivalent yields to be attractive, along with robust fundamentals. Importantly, municipal bonds can offer potential diversification benefits in the form of low correlations to various equity markets, relative to most taxable fixed income mandates. The market is on pace for another year of record supply; however, tight spreads in taxable bonds have helped the markets absorb these high supply levels.

Sentiment

The percentage of bullish investors in the latest AAII survey (the week ending September 23) is 35%, a low reading. The capitulation level is around 20%-25% bulls. The percentage of bearish investors in the AAII survey is 47%. The wall of worry is still in place.
Bull markets peak on euphoria. I don’t think we are there yet.

We will continue to analyze the markets and offer insights again next week.

Source of data (except where noted) is Bloomberg and Franklin Templeton Institute, as of October 1, 2026. Important data provider notices and terms are available at www.franklintempletondatasources.com.

The Franklin Templeton Institute Global Investment Management Survey is a biannual outlook survey designed to give a view across our investment teams. The Franklin Templeton Institute identifies the median across the survey answers and develops the outlook. The survey received responses from around 200 portfolio managers, directors of research and chief investment officers, representing participation across equity, private equity, fixed income, private debt, real estate, digital assets, hedge funds and secondary private markets. Each of our investment teams is independent and has its own views.

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Glossary of Terms

The AAII (American Association of Individual Investors) Sentiment Survey: This survey offers insight into the opinions of individual investors by asking them their thoughts on where the market is heading in the next six months.

Breakeven rates: The difference between yields of Treasury bonds and TIPS for issues of the same tenor/maturity, calculated by subtracting TIPS yields from Treasuries; a measure of inflation.

Capital expenditure (capex): Funds that companies spend to acquire, upgrade or maintain physical assets, such as buildings, technology or equipment, with the purpose of maintaining or growing future operations.

Dollar-cost averaging: An investment strategy wherein a fixed amount of money is invested at regular intervals, regardless of the market's price. Periodic investment plans do not ensure a profit and do not protect against investment loss in declining markets. Since dollar-cost averaging involves continuous investment in securities regardless of fluctuating price levels of such securities, an investor should consider his/her financial ability to continue purchasing through periods of low price levels.

Duration: A measure of how much a bond’s price changes relative to changes in interest rates.

Earnings per share (EPS): The portion of a company's profit allocated to each outstanding share of common stock. An index EPS is an aggregation of the EPS of its component companies.

Fed funds (FF) rate: The interest rate that depository institutions such as banks charge other institutions for holding overnight reserves.

Option-adjusted spread (OAS): Measures the spread between a bond's interest rate and the risk-free rate, while adjusting for any embedded options like callable or mortgage-backed securities.

Price/earnings (P/E): A ratio calculated by dividing a company’s share price by its earnings per share, a measure of valuation.

Tape: A reference to broad market performance, based on the ticker tape that transmitted stock prices during the 19th and 20th centuries.

Taxable-equivalent yield: The yield of a municipal bond investment calculated to reflect the benefits of income tax exemption and to be comparable to the yield of a taxable bond.

Yield spreads/tights: Spreads are the difference between yields on differing debt instruments of varying maturities, credit ratings, issuers or risk levels. “Tight” in reference to spreads indicates small differences in yields.

Indexes

Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator of future results.

Bloomberg US Corporate High Yield Index: Tracks the performance of the USD-denominated, high-yield, fixed-rate corporate bond market.

Cboe Market Volatility Index (VIX): Measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Often called the “fear gauge,” lower readings suggest a perceived low-risk environment, while higher readings suggest a period of higher volatility.

Merrill Lynch Option Volatility (MOVE) Index: Measures the spread between a bond's interest rate and the risk-free rate, while adjusting for any embedded options like callables or mortgage-backed securities.

Purchasing Managers’ Index (PMI): Produced monthly by the Institute for Supply Management, the Manufacturing PMI tracks activity in the manufacturing sector. The Services PMI tracks activity in the services sector. The Composite PMI combines information from the Manufacturing and Services indices.

Russell 2000® Index: A market capitalization-weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000 Index.

Russell 1000 Growth Index: An unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their growth orientation.

Russell 1000 Value Index: A market capitalization-weighted index that measures the performance of Russell 1000® Index companies with relatively lower price-to-book ratios and lower forecasted growth rates.

MSCI EAFE Index: Captures large- and mid-cap representation across 21 developed markets countries around the world, excluding the United States and Canada.

MSCI Emerging Markets Index: Captures large- and mid-cap representation across emerging markets countries, covering approximately 85% of the free float-adjusted market capitalization in each country.

US Dollar Index: A basket of six foreign currencies (euro, Japanese yen, UK pound sterling, Canadian dollar, Swedish krona and Swiss franc) used to track the relative strength of the US dollar, with a higher index value representing US dollar strength.

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