Finding durable value amid shifting currents

Our expectation going into 2025 was that bond yields would stay higher for longer, central banks would look to cut policy rates, and governments would pursue increasingly activist fiscal policies. While these themes played out, we have also witnessed remarkable stability in bond markets. Except for the short-lived period of acute market stress following US President Donald Trump’s “Liberation Day” tariffs announcement, bond investors have, to date, been relatively sanguine. Measures of bond volatility have edged lower and reached levels not seen since just before the inflation shock roiled markets in 2022. Credit spreads have compressed to 15-year tights and global government bond yields have remained remarkably rangebound, despite increasing divergence across countries. Where do we go from here, and what are the key developments to watch as we move into 2026?

Central bank independence questioned

Over the last few years, it has become clear to investors that central banks are much more sensitive to protecting against potential economic shocks rather than targeting inflation in the long or even short term. This focus on avoiding economic pain becomes especially relevant in a context where fiscal policy continues to be expansionary and inflation remains well above central bank targets in most developed economies — a scenario that puts monetary and fiscal policy at odds with each other. This policy disconnect is likely to be exacerbated by governments preferring, or potentially even pressuring, central banks to deliver decisions that support their expansionary budget deficits.

No central bank is more likely to see its independence implicitly or explicitly challenged than the US Federal Reserve (Fed). The incoming Fed Chair when Jerome Powell’s term ends in May 2026, as well as the composition of the rate-setting Federal Open Market Committee (FOMC), will give markets a steer regarding the extent to which monetary policy will be expected to enable fiscal policy decisions. Eventually, this potential reduction in independence risks entrenching inflation and eroding cooperation across policymakers globally.

Risks to the upside, but yields remain attractive

Our base case is for global yields to edge higher throughout 2026, as expansionary fiscal policies and resilient economies should result in higher risk premia across bond markets, despite some weakening in labor markets. Productivity gains could offset some of this upward pressure but there is, of course, substantial timing uncertainty, particularly in relation to AI’s ability to neutralize the negative impact of growing trade restrictions and deteriorating demographics. If business and consumer balance sheets remain resilient, we see little chance of a broad-based recession — barring a major exogenous shock. On the contrary, the economic cycle will be supported by significant capex and fiscal stimulus. As the world adjusts to less efficient supply chains and persistent trade policy uncertainty, governments are signaling they will continue to protect consumers from external shocks, implying further record bond issuance. 

Despite risks to the upside for yields as investors start to react to persistently higher debt, particularly at the longer end of the curve, we think the total return potential for rates remains very attractive. As Figure 1 illustrates, yields on government bonds remain significantly above the levels seen between the global financial crisis and 2022.

Figure 1

When does debt become unsustainable?

The game is up, or certainly becomes more difficult, for countries that lose markets’ confidence. Policymakers across major economies have increasingly turned to fiscal stimulus, delivering the most significant fiscal easing since 2010, if we exclude the extraordinary measures surrounding the COVID pandemic. The key takeaway is that less economic integration and more activist fiscal policy will not only put structural upward pressure on long-term bond yields but also lead to more compressed and more volatile cycles. We expect the theme of divergence across countries and regions to become even more pronounced heading into 2026. 

US
The Trump administration’s trade policy agenda will likely remain a considerable source of uncertainty for global investors, especially as we approach the mid-term elections later in the year. The front end of the US curve will probably reflect an ongoing dovish policy tilt as the Fed will be under renewed pressure to continue its rate-cutting cycle, despite further fiscal expansion through the One Big Beautiful Bill Act. While labor demand has clearly softened, the administration’s immigration policy has reduced supply, leading us to think that the labor market is weaker but will likely hold up in 2026. We note warning signs in some pockets of the credit markets but, absent a major exogenous shock, we do not anticipate a recession, meaning inflation pressures will remain elevated, especially if productivity gains do not materialize. In this scenario, yields could trend higher, particularly at the back end of the curve. 

Europe
We expect continued differentiation across countries. Persistent political turbulence in France has not only cost the country its AA rating but also made it vulnerable to global investors’ concerns over fiscal sustainability and political fragmentation. Without credible fiscal consolidation or a surge in productivity growth, countries that combine high debt levels, large deficits, and elevated interest costs relative to trend growth with heavy reliance on foreign financing are increasingly susceptible to a sudden loss of market confidence. This is likely to drive elevated term premia and nominal yields. It also translates into curve steepening and widening spreads relative to countries deemed fiscally responsible. Among the key beneficiaries of the increased emphasis on fiscal rectitude is the Netherlands, which is emerging as a new risk-free benchmark for the euro area as Germany shifts toward more expansionary fiscal policy. Erstwhile crisis-stricken Greece, Spain, and Portugal are also enjoying increased investor confidence in their fiscal trajectories. 

UK
The UK has long been identified as a bellwether for global investors’ tolerance of countries with high debt levels and an unclear path toward debt consolidation. It also faces a particular challenge from persistent inflation, with a wide distribution of possible outcomes, including renewed economic growth on the one hand and the tail risk of stagflation on the other. Unless inflation is brought down by tighter demand- or supply-side policies, we expect UK rates to remain persistently higher than those of its European counterparts.

Japan
While the domestic inflation dynamics and strong nominal growth should imply the Bank of Japan has the go-ahead to keep hiking policy rates, it will likely remain on hold until it has more visibility on fiscal policy. Our structural view is for higher front-end yields and a stronger JPY, but this theme will only play out if uncertainty clears.

The shifting shapes of yield curves

Since the lows of 2023, term premia have increased across multiple markets as yield curves normalize and investors demand more compensation for holding longer-dated bonds, as illustrated in Figure 2.

Figure 2

Periods of heightened volatility, while challenging, tend also to offer compelling opportunities for active investors — and this time is no different. As markets increasingly price in local growth/inflation dynamics, we see significant potential for alpha generation through: 

• Tactically adjusting portfolio duration and yield curve positioning
• Leveraging mispricing across regions and maturities
• Aligning exposures with differentiated macroeconomic views and policy rate expectations, as markets increasingly price in local growth/inflation dynamics.

Hear more from this expert

Learn more about the factors driving interest rates in the year ahead by listening to this conversation hosted by Fixed Income Investment Strategist Amar Reganti.

Next: read our Credit Outlook