Prediction: The Fed Hikes Rates Once in 2026. Here's What It Means for Bond ETFs.

Based on the current macroeconomic picture, I believe the Fed will hike interest rates once before year-end, most likely at the December meeting. It would mark the first hike since the central bank concluded its last cycle in mid-2023.

That hike could shape how bond exchange-traded funds (ETFs) perform for the rest of the year.

The case for higher rates in 2026

The biggest catalyst for the "higher rates in 2026" narrative is, of course, inflation. In May, the year-over-year rate hit a near-term high of 4.2%. While it came back down to 3.5% in June, it's still well above the Fed's 2% long-term target.

In recent comments before the House Financial Services Committee, new Fed Chair Kevin Warsh made it clear that inflation control is priority one. He said the members of the Fed "have no tolerance for persistently elevated inflation." That doesn't sound like someone who has rate cuts under consideration right now.

Kevin Warsh. Image source: Official White House Photo by Daniel Torok.

The part that complicates trying to figure out the Fed's plans is the volatility of oil prices and inflation. Since the start of the Iran war, we've seen Brent crude prices go from around $70 to briefly above $120, back down to $72, and back up to near $90 again, where they sit right now. With so much of this volatility driven by political rhetoric, it's difficult to say which way prices are headed next.

With the core inflation rate having thus far failed to get back below 2.5%, there's room for the Fed to make a single hike to bring that down.

How different bond categories respond to Fed Funds Rate changes

A hike wouldn't hit every bond ETF in the same way.

• Treasury bills and short-term Treasury ETFs generally react to rate increases quickly. Because of their limited rate sensitivity, prices are likely to change very little, but the yield increase would be reflected within weeks.
• Long-duration bond funds, such as the Vanguard Total Bond Market ETF (NASDAQ: BND), would probably react differently. An ETF holding 20- to 30-year Treasuries or corporate bonds would likely see their share prices get pressured lower, but there's not a direct correlation. The direction of the economy, Federal debt concerns, default rates, and the desire for safety in challenging environments all affect whether long bond prices rise or fall.

In isolation, rate hikes are negative for bond prices. We can say with a high degree of confidence that the Fed is currently leaning in that direction. This could change if there's a long-term resolution in the Middle East that brings oil prices back to pre-war levels. That could make the Fed take more of a "wait and see" approach, but there's little evidence to suggest a resolution is near.

For Treasury bill investors, a rate hike means higher income with little principal risk. Long-term bond investors should be prepared to see falling ETF share prices later this year, although a lot can change between now and then.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Total Bond Market ETF. The Motley Fool has a disclosure policy.