The 2026 trading year opened with an unwelcome surprise for bond investors. A sharp sell-off in U.S. Treasury bonds sent the benchmark 10-year yield surging toward 4.35%, climbing more than 20 basis points from the 4.14% level seen at the close of 2025.

This sudden "yield shock" is being fueled by a combination of factors that threaten to define the fixed-income landscape for the year ahead: resilient labor market data, growing concerns over the long-term fiscal trajectory of the United States, and uncertainty surrounding the Federal Reserve's leadership transition.

What's Driving the Sell-Off

On the first trading day of 2026, the 10-year Treasury yield rose more than 3 basis points to 4.191%. While that modest daily move doesn't capture the full picture, the trend over recent weeks tells a more dramatic story.

Several forces are converging:

  • Fiscal anxiety: The national debt trajectory continues to concern bond investors, with deficit spending showing no signs of abating
  • Fed leadership uncertainty: With Chair Jerome Powell's term expiring in May 2026, the White House is expected to announce a nominee this month, introducing what analysts call a "succession premium" into the yield curve
  • Resilient economic data: Strong labor market readings have pushed back expectations for aggressive Fed rate cuts

The Rate Cut Reality Check

Market pricing currently implies just two rate cuts in 2026, though policymakers remain divided—with most projecting only one reduction. The probability of a rate cut at the January 27-28 FOMC meeting has plummeted to just 15%, according to the CME FedWatch Tool.

Consensus forecasts from firms like Goldman Sachs suggest only two to three quarter-point cuts for the entire year, bringing the federal funds rate to a terminal range of 3.00%–3.25%. This is far from the aggressive easing many had priced in just months ago.

"The most likely scenario for 2026 is a 'slow-motion' easing cycle. Investors expecting rapid rate cuts will need to recalibrate their expectations."

The Fed's Liquidity Response

Behind the scenes, the Federal Reserve has been working to ensure market stability. The December 2025 FOMC minutes revealed officials paying close attention to whether the financial system could quietly run short of cash.

To address these liquidity risks, participants discussed initiating purchases of short-term Treasury securities to maintain ample reserves. Survey respondents expected these purchases to total about $220 billion over the first year—operations intended to support interest-rate control and smooth market functioning, not to change the monetary policy stance.

What Investors Should Watch

The 10-year Treasury yield's interaction with the 4.35% level will be critical in the weeks ahead. Key dates to monitor:

  • January 9: December jobs report—could accelerate or calm the sell-off
  • January 15: December CPI data—inflation readings will be crucial
  • January 21: Supreme Court arguments in Trump v. Cook
  • January 27-28: FOMC meeting—markets expect rates to hold steady

Morgan Stanley's Fixed Income View

Morgan Stanley's outlook offers a potential silver lining: fixed-income markets may rally in the first half of 2026 as central banks pivot from inflation control to equilibrium management. The firm suggests investors consider overweighting government bonds during this period, with the 10-year yield expected to decline into midyear before rebounding just above 4% by year-end.

For now, bond investors face a challenging start to 2026. The yield shock is a reminder that even in an easing cycle, Treasury markets can deliver painful surprises.