Underpriced Downside Tail Risk with a Constructive 2026 Macro Regime

Market-Based Measures Poor Predictors of the Natural Rate of Interest (r‑star)

Market-based measures—especially five-year, five-year-forward TIPS yields—do not reliably predict future real interest rates relative to macroeconomic model estimates. Macroeconomic models imply a modest 0.25–0.50 percentage-point rise in r‑star since 2018, whereas the larger rise in TIPS likely reflects premiums and noise.

• R‑star defined as the real interest rate consistent with supply-demand balance and stable inflation; estimating it is difficult and model-dependent.
• Five-year, five-year-forward TIPS yields have risen sharply and are volatile, but regressions show they have essentially no predictive power for real short-term rates three years ahead.
• TIPS yields can be distorted by liquidity and risk premiums and therefore do not necessarily reflect market expectations of future short rates.

Market Tails and Tales of Uncertainty

Downside tail risks—especially in rates—appear underpriced as the Fed balances potential labor-market weakness against inflation persistence; base case expects inflation to remain the dominant constraint, a modest easing tilt, a steeper curve, and a constructive 2026 for small caps and financials amid a soft-landing backdrop.

• Policy outlook is asymmetric: upside for further Fed hikes is limited, uncertainty centers on timing and extent of cuts which are currently priced back-loaded into H2 2026–2027.
• Markets underprice downside growth/labor tail risk; a sharper rise in unemployment would materially repriced short-term rates lower, but current pricing signals inflation is the dominant concern.
• Neutral nominal policy rate estimated near 3.00–3.25%; short end expected to fall toward ~300–310 bps while the 10-year remains around ~410 bps, allowing potential 2s10s steepening of ~30 bps and Z6/Z8 flattening by ~65 bps by end-2026.

Underpriced Downside Tail Risk; Soft-landing Outlook Supports Small Caps and Financials in 2026

Markets are underestimating downside tail risk—particularly in rates—because pricing remains focused on inflation persistence rather than a potential labor-market-driven slowdown. Macro and equity breadth indicators point toward a soft landing, a modest easing tilt, broader capex re-engagement (led by IT/AI), and a constructive backdrop for small caps and banks in 2026.

Underpriced Downside Tail Risk with a Constructive 2026 Macro Regime

Markets appear to underprice downside tail risk—especially in rates—because policy uncertainty centers on whether labor-market deterioration or stickier-than-expected inflation will dominate; base case is modest easing, steeper 2s10s, improving equity breadth, and growth normalizing into 2026. Key risks remain a sharper rise in unemployment or re-accelerating inflation that would force a materially different policy path.