BlackRock warns: Only two Fed rate cuts in 2026, neutral interest rate has peaked

BlackRock senior strategists Amanda Lynam and Dominique Bly released a recent report indicating that the Fed’s room to cut rates by 2026 is already quite limited. After accumulating a 175 basis point cut since September 2024, the Federal Reserve policy rate is approaching a neutral level. LSEG data shows that the market currently expects only two rate cuts by the Fed in 2026.

Neutral rate approaching end of rate cut cycle

(Source: BlackRock)

The primary reason for the shrinking room to cut rates by 2026 is that the policy rate is nearing a neutral level. The neutral rate refers to the interest rate level that neither stimulates nor restrains economic growth. Since the start of the rate cut cycle in September 2024, the Fed has lowered rates by 175 basis points, with the current federal funds rate range at a relatively moderate level. BlackRock strategists believe this means that further rate cuts are very limited.

From a policy perspective, the Fed still considers labor market risks to be balanced. This “balance” assessment is crucial because it suggests that the Fed does not see the economy overheating requiring tightening, nor does it see recession risks so high that large easing is necessary. In this scenario, the 2026 rate cuts are more likely to be “fine-tuning” rather than “emergency” measures. LSEG data indicates expectations of two cuts, each possibly only 25 basis points, reflecting a moderate pace priced into the market for a “soft landing.”

It is worth noting that the neutral rate itself is not fixed but dynamically adjusts with changes in economic structure. An AI-driven wave of capital-intensive investments is increasing the economy’s potential growth rate, which could simultaneously push up the neutral rate. If the neutral rate rises, the current “approaching neutral” judgment might imply that the room to cut rates is smaller than it appears. BlackRock’s report hints at this possibility, which is a deeper reason for their cautious stance on rate cuts in 2026.

Labor market data shows weakness but not collapse

BlackRock’s outlook on the Fed’s rate cuts in 2026 largely depends on their interpretation of labor market data. Recent US labor market data shows some softness but no signs of sharp deterioration.

Three key signals from the labor market

Unemployment rate modestly rising: The November unemployment rate rose to 4.6%, the highest since 2021, but part of the increase is due to higher labor force participation and government sector unemployment, not a fundamental deterioration in the private sector.

Labor participation rate rising: More people are re-entering the job market seeking employment, which is a positive sign of economic vitality rather than a recession precursor.

Government sector adjustments: The federal government has streamlined personnel, leading to some increases in unemployment, which is a structural adjustment rather than a cyclical recession.

BlackRock strategists note that recent data confirms some of Fed Chair Powell’s previous concerns about downside risks but does not show significant deterioration in employment conditions. This “slightly soft but not collapsing” labor market state is the core basis for the “limited rate cuts” argument. If the labor market were to sharply worsen, with unemployment rising above 5% and large-scale layoffs, the magnitude and frequency of rate cuts in 2026 would likely increase significantly. However, BlackRock expects this scenario to be unlikely.

AI revolution reshapes rate cut logic and investment environment

The most striking part of BlackRock’s report is about how AI is changing the underlying logic of economic growth and monetary policy. The global economy and financial markets are undergoing a major transformation, especially driven by artificial intelligence. Technology is becoming capital-intensive, and the speed and scale of AI development could be unprecedented. This shift from light capital growth to capital-intensive growth is profoundly changing the investment environment.

Building AI requires substantial upfront investments in computing, data centers, and energy infrastructure. BlackRock expects capital expenditures in AI to continue supporting economic growth into 2026, with contributions to US economic growth being three times the historical average this year. This capital-intensive stimulus could persist into next year, maintaining stable economic growth even as the labor market cools. This is one of the key reasons why the Fed’s room to cut rates in 2026 is limited, as the economy does not need more monetary stimulus.

Over the past 150 years, all major innovations—including the steam, electricity, and digital revolutions—have failed to lift the US economy out of a long-term 2% growth trend. But AI is the first to make breaking this trend possible. Why? AI is not only an innovation itself but also has the potential to accelerate other innovations. It requires self-learning and improvement, which can speed up creativity and scientific breakthroughs. If this growth breakthrough is realized, the economy’s potential growth rate will increase, and the neutral rate will rise accordingly, further limiting the Fed’s room to cut in 2026.

The core characteristics of the investment environment have changed: system leverage has increased, capital costs are higher, returns are concentrated among a few winners, excess return opportunities are greater, and large-scale investments are needed. This environment favors active investing over passive index tracking. Driven by a few powerful forces, it is difficult not to make significant judgments about market direction, so a neutral stance no longer applies.

Adjusting investment strategies for a limited rate cut environment

Facing the prospect of limited room for rate cuts by the Fed in 2026, BlackRock offers clear investment strategy recommendations. Tactically, they maintain an overweight position in US equities, mainly based on the expanding AI theme, which has been supported by the rate cuts boosting market risk appetite. This year, the AI theme has extended to include more markets such as China and Korea. They remain neutral on European equities but are more optimistic about sectors like financials and industrials.

Strategically, BlackRock emphasizes a scenario-based approach to predicting AI winners and losers. They rely on private markets and hedge funds to obtain unique returns and link their portfolios to macroeconomic trends. Infrastructure equities are attractive valuations with strong structural demand support. Private credit remains promising, but they expect future market divergence, highlighting the importance of selecting fund managers.

In fixed income, BlackRock recommends seeking “alternatives” to hedge portfolio risks, as long-term US Treasuries no longer serve as a stable investment. They see gold as a tactical investment driven by specific factors but not suitable as a long-term hedge for portfolios.