The third quarter largely continued the economic trends observed during the first half of 2026, though arguably at an even stronger pace than many forecasters anticipated. Despite a host of developments that would normally be expected to slow economic activity, the U.S. economy continued to expand, and consumers remained surprisingly resilient.
Many of the same themes dominating headlines earlier in the year remained front and center throughout the quarter. Geopolitical instability surrounding the ongoing conflict involving Iran continued to drive elevated energy prices and inflationary concerns. Meanwhile, Federal Reserve Chair Kevin Warsh and policymakers finally moved beyond warning investors about inflation and formally initiated a new rate-hiking cycle in September. Trade policy also re-emerged as a source of uncertainty as tariffs were expanded and diplomatic relations between the United States and Canada deteriorated.
On the fiscal front, another symbolic milestone was reached as U.S. gross national debt surpassed $40 trillion for the first time in history. While markets have largely become desensitized to the growing debt burden over the years, the continued expansion of federal borrowing raises legitimate concerns regarding long-term fiscal sustainability and the amount of Treasury supply that investors must ultimately absorb.
Additionally, the Congressional Budget Office projects the federal budget deficit to exceed $2 trillion. What makes this development particularly striking is that it is occurring against the backdrop of a healthy economy and strong labor market, conditions that would ordinarily support fiscal improvement rather than a widening deficit.
Financial markets delivered mixed signals. Equity investors remained focused on the continued growth potential associated with artificial intelligence and pushed the S&P 500 briefly above the 7,800 level. At the same time, bond market participants appeared increasingly concerned as Treasury yields climbed to levels not seen in nearly twenty years. The benchmark 10-year Treasury yield moved above 5%, a level that has historically represented a meaningful hurdle for both consumers and corporations.
Taken together, the quarter offered another reminder that economic resilience and growing risks are not mutually exclusive. While economic growth remains intact, the list of challenges facing policymakers, businesses, and investors continues to grow.
For much of the past two years, economists have debated when restrictive monetary policy would finally begin to materially slow economic growth. Thus far, the answer remains elusive.
The third and final estimate of second-quarter GDP showed growth of 2.2%, marking a significant upward revision from the earlier estimate of 1.5%. Equally notable, first-quarter GDP was revised higher from 2.1% to 2.5%. Combined, these revisions reinforce the view that the economy entered the second half of the year with considerably more momentum than previously understood.
At the time of this writing, the advance estimate for third-quarter GDP has yet to be released. Preliminary estimates generally suggest another quarter of growth exceeding 2%. The Atlanta Federal Reserve's GDPNow model has at times projected growth in excess of 5%, a figure that appears aggressive but nevertheless highlights the underlying strength of recent economic activity.
The Federal Reserve's Summary of Economic Projections currently points toward full-year growth of approximately 2.3%. That estimate aligns closely with my expectations, though growth may be skewed modestly to the upside if interest rates stabilize or retreat from current levels.
Ultimately, the health of the U.S. economy continues to depend heavily upon the consumer. Household spending represents approximately 70% of domestic economic activity. Despite elevated interest rates, persistent inflation, and geopolitical uncertainty, consumer demand remains remarkably resilient. As goes the consumer, so goes the economy, and thus far, the consumer continues to provide meaningful support.
The Federal Reserve provided one of the most consequential developments of the quarter.
While the July FOMC meeting resulted in no change to the Fed Funds target range, important signs emerged suggesting policymakers were becoming increasingly uncomfortable with inflation's lack of progress. Three governors dissented against holding rates steady, signaling a growing divide within the committee and foreshadowing future action.
The annual Jackson Hole Symposium ultimately served as the turning point.
Chair Warsh repeatedly emphasized concerns surrounding persistent inflation and questioned whether policymakers had achieved sufficient progress toward restoring price stability. While he continued to avoid providing explicit forward guidance, his comments effectively communicated the Fed's reaction function and prepared markets for policy action.
Markets responded quickly. Fed Funds Futures shifted dramatically following Jackson Hole. What had been a market expecting unchanged rates in September evolved into overwhelming expectations of a hike by the time policymakers convened later in the quarter.
The September meeting delivered exactly that outcome. The FOMC unanimously approved a 25-basis-point increase in the Fed Funds rate and signaled that additional tightening remained possible. The updated dot plot revealed that a majority of committee members anticipate at least one additional increase this year, while several members favor even further tightening.
Perhaps most important was the message delivered alongside the rate increase. Chair Warsh repeatedly emphasized "price stability" throughout his press conference, sending a clear signal that inflation had become the dominant policy concern.
From a governance perspective, the quarter reinforced the Federal Reserve's independence. Despite ongoing political pressure to pursue easier monetary policy, policymakers demonstrated a willingness to make unpopular decisions in pursuit of their mandate. Whether one agrees with the policy decision or not, maintaining institutional credibility remains an important component of effective monetary policy.
One of the most important macroeconomic themes of the year continued throughout the third quarter: the economic consequences of the conflict involving Iran.
Early arguments suggesting the inflationary effects would prove temporary increasingly appear overly optimistic. While the supply disruptions initially resembled a traditional commodity shock, the longevity of the conflict has altered the discussion. What was expected to be temporary inflationary pressure now carries characteristics of a more persistent challenge.
Market participants have gradually become desensitized to headlines suggesting progress toward peace. Repeated announcements regarding potential negotiations have largely failed to produce meaningful breakthroughs, causing investors to increasingly discount optimistic developments until tangible progress emerges.
Oil prices reflect this reality.
Brent crude remained above $100 per barrel for much of the quarter, highlighting persistent concerns regarding production and transportation disruptions throughout the region. Even in the event of an immediate resolution, meaningful restoration of oil production and distribution would likely require months rather than weeks.
Recent attacks targeting energy infrastructure and continued challenges involving transit through the Strait of Hormuz further reinforced concerns regarding supply reliability. Consequently, energy prices continue to incorporate a significant geopolitical risk premium.
While an eventual resolution remains possible, investors should be cautious about assuming a quick return to pre-conflict energy prices. Markets increasingly appear to be pricing a more prolonged disruption.
The Federal Reserve's dual mandate became increasingly one-sided during the quarter.
Employment conditions remained healthy enough that policymakers felt comfortable directing most of their focus toward inflation. Unfortunately, inflation data failed to provide the meaningful improvement many had hoped to see entering the second half of the year.
The expectation that moderating commodity prices would help pull inflation lower proved largely incorrect. Instead, core inflation measures remained stubbornly elevated and continued to indicate price pressures inconsistent with the Fed's 2% objective.
The challenge facing policymakers is becoming increasingly familiar: the last mile of inflation reduction often proves significantly more difficult than the initial decline. While inflation has moved substantially lower from peak levels earlier in the cycle, further progress continues to be frustratingly slow.
This reality ultimately forced the Federal Reserve to acknowledge that policy was insufficiently restrictive and contributed directly to September's rate increase.
At present, core CPI, core PPI, and core PCE continue to suggest that inflation remains too elevated to justify a meaningful shift toward easier monetary policy. Until clearer evidence of sustained improvement emerges, investors should expect inflation to remain a primary market driver.
Perhaps no market delivered a stronger message during the third quarter than the Treasury market.
The 10-year Treasury yield began the quarter at 4.46% before surging through prior highs, exceeding 5%, and ending near 5.30%. Interest rates were pushed to levels not seen since the early 2000s.
The entire yield curve shifted remarkably higher. The 2-year Treasury approached 4.95%, while the 30-year Treasury bond nearly reached 5.65%. These moves reflected a combination of factors, including persistent inflation, Federal Reserve tightening, and concerns regarding fiscal sustainability.
The rapid increase in yields cannot be attributed solely to monetary policy. Investors are increasingly evaluating the implications of a national debt exceeding $40 trillion and the substantial Treasury issuance required to finance ongoing deficits. A growing supply of bonds combined with fiscal uncertainty has likely contributed to a higher term premium across the yield curve.
Equally noteworthy was the significant flattening of the yield curve. Two-year and ten-year Treasury spreads narrowed considerably during the quarter, indicating growing market worry regarding future economic growth. Historically, such flattening has often emerged during late-cycle environments when investors become increasingly concerned about slower growth ahead.
Higher rates are also beginning to produce tangible economic consequences.
During the ZIRP era, capital was abundant and inexpensive. That environment no longer exists. Higher borrowing costs effectively act as a tax on leveraged corporations, raising financing expenses and forcing executives to scrutinize investment decisions more carefully. Once 10-year Treasury yields move above 4.50%, corporate finance departments begin paying close attention. Above 5%, many marginal projects struggle to generate acceptable returns.
There is, however, a positive side.
For the first time in nearly two decades, fixed-income investors can lock in truly attractive yields. In the 10-Year space, single-A rated corporate bonds offer yields near 6%, while tax-equivalent municipal yields are around 7%, near 4.50% tax-free. After years of receiving little compensation for duration risk, bond investors are finally being rewarded.
The bond market remains a notoriously skeptical observer of economic conditions. While equities often focus on growth opportunities, bond investors focus on risks. The message from fixed income today is not necessarily recession, but caution. That warning deserves attention.
One of the primary reasons the economy has remained resilient continues to be the labor market.
By most conventional measures, employment conditions remain healthy. The unemployment rate remains consistent with what economists generally define as full employment, and Fed officials have repeatedly characterized labor conditions as supportive of continued expansion.
However, the details warrant a more careful examination.
Payroll growth has slowed meaningfully relative to post-pandemic trends. Under normal circumstances, such moderation might signal deteriorating labor demand. Yet the broader context suggests a more balanced interpretation.
Perhaps more encouraging is the continued improvement in wage growth among lower-income households. Sustained gains for workers at the bottom of the income distribution improve economic participation and contribute to healthier consumer spending trends.
One area deserving continued monitoring is the disconnect between job openings and hiring activity. Job openings remain elevated, yet actual hiring has failed to accelerate materially. Employers appear willing to post opportunities while remaining reluctant to make long-term commitments.
This divergence could simply represent cautious corporate behavior. It could also signal growing uncertainty regarding future economic conditions. Regardless of the explanation, it remains a development worth watching closely.
Housing remains one of the economy's most challenged sectors.
Affordability continues to serve as the primary obstacle for both existing and prospective homeowners. Existing borrowers remain locked into historically attractive mortgage rates obtained during prior years, creating little incentive to sell. This contributes to ongoing inventory shortages and limits housing turnover.
Potential buyers face an entirely different challenge. Home prices remain elevated, inventories remain constrained, and mortgage rates near 7% continue to pressure affordability.
Importantly, investors must avoid thinking about housing as a single national market.
The Northeast continues to experience significant supply shortages and strong price appreciation. The Midwest remains one of the strongest performing regions while maintaining relatively attractive affordability metrics. In contrast, parts of the South have begun experiencing greater supply availability and slower demand growth, though regional outcomes vary significantly.
The national housing market continues to show modest aggregate appreciation, but beneath the surface, conditions differ dramatically depending on geography.
Unfortunately, meaningful affordability improvement appears unlikely in the near term. Without substantially lower mortgage rates or significantly higher housing supply, housing is likely to remain constrained well into 2027.
One of the most encouraging developments of the quarter was continued improvement among lower-income households.
For several years, economic gains appeared disproportionately concentrated among higher-income consumers. Recent trends suggest that the imbalance is beginning to moderate.
Consumer spending growth among lower-income households strengthened throughout the quarter, while wage growth for the same demographic exceeded that of higher-income earners. Importantly, wage gains moved above 5%, representing a meaningful improvement in purchasing power.
Certainly, caution is warranted. Rising credit card utilization can sometimes indicate financial strain rather than economic strength. Given elevated borrowing costs, that possibility cannot be ignored.
However, improving wage growth combined with signs of increasing savings rates suggests a more constructive interpretation. Rather than purely debt-fueled consumption, recent data indicates broader economic participation and improving household finances among traditionally vulnerable segments of the population.
If sustained, this development would represent a meaningful positive for the economy. Expansions built upon broad participation tend to prove more durable than those concentrated within a narrow segment of consumers.
Equity markets delivered another quarter of resilience.
The S&P 500 reached new highs during the summer before entering a period of consolidation through August and September. The primary driver remained earnings growth and continued investor enthusiasm surrounding artificial intelligence infrastructure spending.
Importantly, market participation broadened beyond the largest technology companies. While AI-related investments remain the central growth narrative, improved earnings expectations across a wider range of industries contributed to market stability.
The most surprising aspect of the quarter may have been equities' ability to withstand higher rates. Historically, significant increases in Treasury yields would have produced greater pressure on stock valuations. Instead, improving earnings forecasts largely offset valuation concerns.
Looking ahead, I remain constructively cautious. The AI capital expenditure cycle remains intact and should continue supporting economic activity and corporate profitability. However, higher interest rates, elevated energy costs, geopolitical uncertainty, and slowing growth all represent legitimate risks.
The equity story remains favorable, but the margin for error has narrowed.
As we move toward year-end, my outlook remains constructive, though with a greater appreciation for the challenges ahead.
Economic growth continues to exceed expectations despite a lengthy list of headwinds. Consumer spending remains healthy, the labor market remains stable, and corporate earnings continue to support investor confidence.
My base-case scenario remains a soft landing characterized by economic growth in the 2.0% to 2.5% range through the remainder of 2026 and into 2027. Admittedly, the path has become narrower. The Federal Reserve has initiated a tightening cycle, energy prices remain elevated, and fiscal concerns continue to mount.
Nevertheless, the underlying strength of the economy continues to provide important ballast.
The Federal Reserve deserves some credit for finally moving policy toward a more restrictive stance. Throughout prior commentaries, I expressed concern that monetary policy was not sufficiently restrictive to address persistent inflation. The September hike represents an important step in the right direction.
The challenge now becomes execution. Policymakers must operate with precision. The objective is to lower inflation without unnecessarily damaging economic growth. In medical terms, the economy requires a scalpel rather than a chainsaw.
Higher interest rates are likely to remain with us longer than many investors previously expected. However, we are likely closer to the end of the interest-rate adjustment than the beginning. Slower growth will eventually emerge, and inflation pressures should continue to moderate over time.
At the same time, fixed-income investors now have an opportunity that has not existed for nearly two decades: the ability to lock in historically attractive yields.
Equities should continue to benefit from AI-driven investment, solid corporate profitability, and innovation. While additional gains remain possible, I believe a period of increased volatility and potential market consolidation remains likely before the next leg higher develops.
Unknown risks remain ever-present. Geopolitical tensions, trade disputes, fiscal concerns, and potential policy missteps all have the ability to alter the outlook. Yet volatility often creates opportunity for disciplined investors willing to maintain a long-term perspective.
Ultimately, the dominant theme of this quarter remains unchanged: the economy continues to demonstrate resilience in the face of mounting pressure. The risks are real, the challenges are growing, and policymakers have difficult decisions ahead. Nevertheless, strong consumers, healthy corporate balance sheets, attractive fixed-income opportunities, and continued technological innovation provide a foundation for cautious optimism as we move into the final months of 2026 and begin looking toward 2027.
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