(Bloomberg) -- The most involved discussion at State Street Corp.'s $6 trillion investment-management arm is around the outlook for 10-year US Treasury yields — the main financial metric targeted by Treasury Secretary Scott Bessent.
"I'll be honest with you, I'm not sure I can even get my head around it some of the times," Lori Heinel, State Street's chief investment officer, said in an interview last week. "This is the biggest debate we have amongst ourselves."
Coming into 2026, State Street expected yields to fall toward 3.5% or lower this year, but instead they've been on the rise. They surpassed 4.7% last week for the first time since the month President Donald Trump began his second term. The increase underscores how the Iran war, by buoying oil prices and fanning inflation worries, has upended expectations around the economy.
The US economy's resilience in the face of the hostilities, thanks in part to the artificial-intelligence boom, has helped shift thinking at the Boston-based financial giant.
"That's the thing I've been sort of most struck by — how little that has impacted what's going on here in the US," Heinel said in reference to the war.
While "the risks probably are a bit to the upside still from here" for 10-year yields, current levels offer good value, she said. "Our latest tactical allocation shift was to put more into long durations and credit."
About a month and a half ago, State Street "capitulated" on its view that the Federal Reserve would cut rates this year, said Heinel. In 2024, she correctly anticipated the central bank would kick off an easing cycle with an outsize half-point reduction.
She now sees the Fed standing pat for 2026, rather than lowering its benchmark. The bond market, meanwhile, is fully pricing in a Fed hike by September, and sees a roughly 35% chance of an increase at this week's meeting.
"But we still think the next move is a cut, not a hike," Heinel said.
"We still think that things likely do slow a bit from here" for the US economy, with inflation subsiding and policymakers possibly reducing rates in early 2027, she said. "So we think that the risk-reward remains on the side of yields probably drifting a bit lower from here."
Economists and strategists surveyed by Bloomberg this month agreed, with a median 10-year yield forecast of 4.39% for the first quarter of 2027. Yields on the maturity dipped to start the week, dropping below 4.7%, as crude prices slid on signs of easing Middle East tensions.
Main Measure
Soon after taking office, Bessent last year identified 10-year rates as his main financial measure, given their broad economic impact as a benchmark for loans such as mortgages and corporate borrowings.
Bessent brought up the power of the bond market in an appearance last month.
Alluding to the importance of the Fed containing inflation to avert any surge in yields, Bessent said June 23, "Look, the president understands – he and I have talked about it quite a bit." Speaking at the Economic Club of New York, Bessent said, "The bond market has taken out more governments than howitzers" have done.
Heinel distinguished between her team's trading strategies and their view of the longer-term outlook.
The "sweet spot" for tactical portfolios has around a nine-month horizon, changing on a monthly basis, she said. "We don't trade on" structural capital-market assumptions, she said.
Those longer-term assumptions have been evolving. Geopolitical tensions mean the end of the old globalized supply chain. Along with higher fiscal deficits, that's contributing to "structurally higher inflation," Heinel said. "The equilibrium rate of interest is probably higher than it was."
One thing the State Street manager doesn't see: political influence that forces the Fed into slashing rates — a move economists warn would send inflation and longer-term yields higher. Fed Chairman Kevin Warsh in congressional testimony this month promised that he will defend the central bank's independence from the White House and President Trump.
"We have a lot of conversation about the independence of the Fed, and whether we believe that the Fed will remain independent under the current administration," Heinel said. "And our view is, unequivocally, yes."
(Updates market-implied expectations for this week's Fed meeting. A previous version corrected futures pricing in eighth paragraph.)
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