Come together!

Come together

Globally, interest rates are converging. The average difference between policy rates of major central banks peaked in 2023 and has been moving lower since. It should continue to move lower as the US Federal Reserve (Fed) reduces its policy rate – with the next move possibly coming before Christmas – and the Bank of England responds to lower inflation and a tighter fiscal environment in 2026. Already, in the Eurozone, the UK and Canada, the real policy rate – proxied by the policy rate minus the current inflation rate – is close to zero (even if inflation itself is still above target). Economists will argue about where the neutral policy rate is but the 2026 outlook suggests central banks will be comfortable with the interest rate levels currently being discounted in market pricing. Globally, monetary policy should be much easier at the start of 2026 relative to where it has been since the end of 2022. 

One vote 

The Bank of England left the bank rate unchanged on 5 November. However, it took a deciding vote by Governor Andrew Bailey to keep interest rates at 4%. The main cause of disagreement between policymakers was on the underlying inflationary pressures in the UK economy. However, the timing of the Budget may have also played a role. There has been a growing sense the Chancellor Rachel Reeves will recognise the need to credibly tighten fiscal policy, potentially including an adjustment to income tax rates or allowances. Gilt yields moved to their lowest levels of the year at the end of October. They have since backed up, but the market is not sending any obvious signals of impending panic ahead of 26 November. Lower rates are likely to follow with a sub-3.5% bank rate now firmly priced by interest rate futures. 

Calmness in rates 

Lower and stable global rates reinforce the view that most fixed income market returns will come from income. Rates curves will offer opportunity for this, but it requires accepting more duration risk in portfolios. Although there are inflation and fiscal risks, for now markets are not acting in anticipation of a worsening of those risks. And in the absence of a significant deterioration in the fiscal outlook, major bond yields are not likely to diverge too much from one another – dispersion today is higher than it was during the period of super low interest rates, but is similar to where markets traded in the decade prior to the global financial crisis. So, the rates markets outlook is for lower returns and less volatility.

Lower hedging costs coming

The convergence of interest rates has implications for multi-currency strategies. Hedging US dollar exchange rate risk has been expensive for Japanese, Swiss and euro-based investors in the past couple of years. As the Fed cuts rates, these hedging costs will be less punitive. For example, the implied gap between US dollar and euro rates is 1.0% by end-2026 (compared to 2.0% today). The gap between US dollar and Japanese yen rates is priced to fall to 2.0% compared to 3.5% today. With the US yield curve steeper and credit spreads wider, US fixed income returns hedged into euro, yen and Swiss franc will look more attractive than for some time. 

Credit outlook 

Stable and lower rates should be supportive for credit returns. The proviso here, of course, is that credit spreads are thought to be tight with little room for further compression between bonds of different credit quality. There are a couple of things to consider. The first is that government bonds have become cheaper in terms of their comparison to interest rate swap rates i.e. bond yields are higher than swap rates. So, if you consider yields on corporate bonds versus swap rates, the spread is not as tight as it appears when you use government bond yields as the comparator. Some institutional investors use swap rates as their benchmark, so credit remains attractive - in the US investment grade market the swap spread is around 120 basis points (bp) relative to the credit spread against US Treasuries of 82bp.

The other observation is the compression of spreads means investors do not have to give up too much yield to improve the credit quality of the portfolio. Between the AA and BBB-rated buckets of the European investment grade corporate bond index, the difference in yield is just 38bp, the lowest it has been since the indices were first published by Bank of America/ICE in 2016. The similar spread in the US market is around 50bp, also a low. The point here is that if investors are concerned about valuations and potential volatility in credit markets, they can lock in decent yields while improving their average credit quality exposure. 

Corporates remain healthy 

If there is going to be fixed income market volatility, I am more inclined to think it will be credit, rather than rates, driven. Historically, large drawdowns have resulted either from credit or rate shocks, and the latter is not on the agenda, unless there is a supply-side driven inflation shock. Recently there have been concerns about credit markets, especially on the private side, but public markets have been extremely resilient. This makes sense given the macroeconomic backdrop and the strength of nominal growth. Third quarter earnings reports provide more compelling evidence for that. Bloomberg data suggests that the S&P 500 universe delivered revenue growth of above 8%.

Always something there to worry about 

On the macro risk side we should expect periods that create some risk market underperformance over the next year. Right now, the US is operating under a federal government shutdown which is important because it means that spending on government supply purchases and employees is being disrupted, and because markets are operating without their usual supply of timely economic data. The poor showing for the Republican Party in last week’s gubernatorial and mayoral elections reflects voter discontent with the shutdown. In a year’s time – when mid-term elections are held - it will be an even bigger electoral test for Donald Trump’s administration and the Republican leadership in Congress. How opinion polls evolve between now and then, and how the US President responds, could have significant implications for market confidence. The shutdown, a potentially weaker economy partially hidden by the lack of official data, and ongoing cost-of-living concerns could all contribute to a more confrontational relationship between the White House and Congress for the following two years after the mid-terms depending on next year’s results.

Keep the machines running 

However, in the meantime there remain good reasons to be bullish. US growth has been resilient and it is improving in Europe. The artificial intelligence (AI) capex boom is not slowing down. I have started to read a book about AI entitled Genesis - authored by the late Henry Kissinger, and two so-called tech titans, Eric Schmidt and Craig Mundie. Like other AI literature, it engenders both optimism and fear, but the key is the enormous potential for machines to become more intelligent than humans and for that to provide the chance for huge gains in material and social living standards. Corporates can invest in AI today; they can reap the benefits of increased productivity. This has broader economic benefits. There is a bull case and, for now, anything superficial to the economic outlook such as election results, or bad-tempered tweets, which lead to wider credit spreads could be seen as a buying opportunity.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 6 November 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.