Rates Turn Higher Again: Inflation, Oil and Valuation

Introduction

On September 16, 2026, the Federal Open Market Committee raised the federal funds target range by a quarter point to 3.75-4.00%, its first increase since 2023 after five straight holds. In March, the median policymaker had still expected one more cut in 2026. The reversal matters far more than its 25 basis points suggest, because much of the deal market since 2024 was priced on a quiet assumption that the next move in rates would be down.

This article covers why 2026 turned, how the move flows into discount rates, terminal values and LBO affordability, which businesses hold value, and how to set rate assumptions when the path is uncertain. The transmission channels are explained in how interest rates and market cycles affect valuation; the cutting cycle that came before is recorded in the interest rate pivot.

The turn came from energy, not from an overheating economy. After the US-Israel-Iran conflict began on February 28 and tanker traffic through the Strait of Hormuz collapsed, Brent averaged $103 a barrel in March. The EIA's October Short-Term Energy Outlook puts the September average at about $114, with a daily high of $131 after attacks on Saudi Arabia's East-West bypass pipeline. The September consumer price index rose 3.7% from a year earlier, with energy up 20.4%, while core inflation was a more contained 2.6%: the signature of supply-shock inflation, where the central bank has to judge whether the shock will leak into wages and expectations.

Between the March projections and September's, the committee's median path swung from one more cut to one more hike before year-end, with no cuts in 2027.

Why the 10-Year Yield Matters More Than the Policy Rate

For valuation, the number that matters is the long-term Treasury yield: it is the risk-free rate in CAPM and the base on which corporate debt is priced. The Fed moved 25 basis points; Treasury's daily par yield curve shows the 10-year up more than four times that, peaking at 5.31% on October 5. Markets priced in more hikes, higher inflation and a larger term premium well before the committee acted.

Term Premium

The extra yield investors demand to hold a long-term bond instead of rolling over a series of short-term bonds for the same period. It compensates for uncertainty about future inflation and interest rates, so it tends to rise when inflation becomes less predictable, lifting long-term yields (and the risk-free rate in discount rates) even when the policy rate does not change.

Credit spreads, by contrast, barely moved: PIMCO's October credit review found investment grade spreads effectively flat against February at the end of September. The higher cost of debt therefore came almost entirely through the base rate, not through lenders repricing credit risk.

Take a WACC built in February on a 4.0% risk-free rate and rebuild it in October at 5.1%, holding the rest constant: beta of 1.0, a 5.0% equity risk premium, 70/30 equity-to-debt, a flat 1.5% credit spread and a 25% tax rate.

Because both legs are built on the risk-free rate, WACC rises by about the same amount. The value effect runs through the perpetuity growth formula, whose denominator is the gap between WACC and long-term growth:

Higher inflation does not rescue the answer by raising terminal growth. A supply shock lifts nominal cash flows for a year or two, but the long-run growth rate in the perpetuity growth method should track long-run inflation, and the Fed's September projections still show PCE inflation falling to 2.3% in 2027 and 2.0% in the longer run. Raising g to match 2026 CPI would offset the higher WACC with a number the economy is not expected to sustain (the generic math is in how interest rates drive M&A and LBO activity).

Sponsors feel rates through the cost of leverage. Leveraged loans float over SOFR, which tracks the policy rate, so each hike adds directly to cash interest on unhedged term loans; fixed-rate high-yield bonds price off a five-year Treasury yield that rose from 3.51% on February 27 to 4.89% on October 16. Because lenders size debt to interest coverage, a higher all-in rate means fewer turns of EBITDA, a larger equity cheque for the same price and a lower price at the same target IRR.

The result is a lower LBO floor, even with abundant equity waiting to be invested, a tension explored in PE dry powder and the pressure to deploy. Mergermarket's nine-month 2026 review found global sponsor investment down 11% year on year at $584.2 billion, and North American megadeals down from 19 in the second quarter to six in the third, with the head of Mergermarket naming financing conditions among the risks to fourth-quarter closings. How much of the gap direct lenders can fill is covered in the private credit boom and LBO financing.

Rising rates reopen the valuation gap that took most of 2024 and 2025 to close. Sellers anchor on the record-chasing first half of 2026 while buyers reprice to a higher cost of capital, so, as in 2022, processes lengthen and earnouts and stock consideration return. The reversal also breaks three easing-cycle habits:

Two questions sort the resilient from the exposed: cash flow duration (how far in the future a company's value sits) and pricing power (whether it can pass inflation on to customers).

In practice, 2026 sector moves mixed rate effects with the oil shock and the AI trade, as sector rotation shows.

The hard part is the range of plausible next moves. The Fed projects another hike, oil could fall quickly if Hormuz traffic recovers (the EIA has Brent averaging $84 in 2027), and the 10-year rose 35 basis points in the two weeks to its October peak.

Normalized Risk-Free Rate

A risk-free rate set at a sustainable long-term level instead of the spot Treasury yield on the valuation date, used when spot yields look artificially depressed, as during quantitative easing. Kroll's January 2026 cost of capital guidance pairs a 5.0% US equity risk premium with the higher of a 3.5% normalized rate or the spot 20-year Treasury yield; with the 20-year at 5.47% on October 16, the spot yield governs.

A practical sequence keeps those choices visible and easy to refresh:

None of this assumes rates will keep rising. It recognizes that the asymmetry of 2024 to mid-2026, when the only debate was how fast rates would fall, is gone, and that a defensible valuation now shows what happens if they do not.