Summary

1. Policy divergence deepens: ECB holds, Fed cuts. We expect the Fed to deliver two rate cuts in 2026, bringing the terminal rate to 3.25%, whilst the ECB remains on hold throughout the year with the first hike forecast for September 2027.

2. UK gilts stand out, US and German bonds fairly valued. Our 12-month targets for 10-year yields are 2.75% for Germany, 4.25% for the US, and 4.30% for the UK. We maintain a Positive view on UK gilts. We remain Neutral on both US Treasuries and German bunds as both trade close to our targets.

3. Fed independence under unprecedented attack. The Trump administration's attempts to remove Fed Governor Lisa Cook and investigate Chairman Powell have sparked global outrage. Whilst markets remain calm, the implications for Fed autonomy and the US sovereign rating warrant close attention.

4. Agency MBS: superior alternative to investment grade credit. Given their similar yield (4.7%), lower duration and government guarantee, they offer an attractive option. Additionally, Trump's $200 billion GSE purchase directive provides technical support, while IG corporates face significant supply pressures.

5. 2026 Top Conviction: EM local currency bonds offer compelling carry and FX upside. EM local currency bonds offer compelling yields around 6%, rate cut potential exceeding market pricing and FX appreciation against the dollar. Euro-based investors should consider exposure with FX hedging. Technical support from under-ownership and strong fundamentals support our Positive view.

6. Where to find value: We favour UK gilts, Emerging Markets local currency bonds, US Agency MBS, US TIPS, EUR/GBP investment grade corporate bonds.

Policy divergence: ECB holds, Fed cuts

European Central Bank (ECB)

Data-driven restraint: Eurozone inflation stabilised near the ECB's 2% target in late 2025. The December staff projections forecast 1.9% average inflation in 2026 alongside 1.2% GDP growth, allowing policymakers to deem current rates "neutral".

ECB holds firm: Inflation is more likely to overshoot than undershoot the ECB's target at the end of 2026, in our view. The Governing Council's rhetoric underscores the lack of urgency for change, with French official Villeroy de Galhau dismissing 2026 hikes as "fanciful".

Steady through 2026: We expect policy rates to remain unchanged throughout the year. The market concurs, pricing out easing within the next 12 months. We forecast the first move (a rate hike) in September 2027, when growth and inflation should pick up thanks to German and EU fiscal plans.

US Federal Reserve (Fed)

Sticky disinflation: December's CPI confirmed that headline inflation remained at 2.7% year on year. Alternative measures (trimmed mean, median, supercore) still point to a gentle rise, around 2.75% to 3.10%. We expect inflation to peak in the second quarter before easing modestly.

Cooling labour market: The latest jobs report shows the labour market is cooling in orderly fashion. The "low hire, low fire" trend persists and the unemployment rate has edged lower.

Our view: Some Fed officials still anticipate rate cuts citing weak payroll growth. Political pressure to lower rates has become intense (see the Topics section). The newly appointed Federal Reserve Chair will be compelled to cut rates at the June FOMC meeting, or he will be seen as a weak leader if he fails to persuade his colleagues to do so. We retain our forecast of two rate cuts this year, now scheduled for June and September, which will bring the terminal rate to 3.25%.

Bond yields

Differentiated opportunities

Divergent trajectories: Government bond yields have displayed contrasting dynamics in early 2026. US 10-year Treasuries remain range-bound around 4.17%, reflecting balanced inflation and fiscal concerns. German bunds hold steady near 2.82%, supported by expected bond issuance. UK gilts have seen the most pronounced moves, retreating from above 4.60% in early January to 4.40% as weaker-than-expected PMI data, softer wage figures and dovish BoE commentary eased inflation concerns.

Positioning for targets: Against our 12-month targets of 2.75% for Germany, 4.25% for the US and 4.30% for the UK, gilts offer some room for appreciation in addition to attractive carry. The recent dovish shift in BoE messaging, combined with softening growth momentum, supports our constructive view. Both Treasuries and bunds trade close to our forecasts, warranting a neutral stance. Market pricing now reflects more aggressive BoE easing than previously anticipated, which should underpin gilt performance over coming months.

Policy rates will be lower in 2026: the Federal Reserve will complete its cutting cycle by end-2026 in our view, delivering two additional rate cuts to 3.25%, extending the reductions initiated in 2024 as inflation moderated from cycle peaks. The ECB completed its easing in 2025, and shall remain on hold in 2026; we do not expect rate hikes before mid-2027. The Bank of England will continue its gradual reduction throughout 2026, we think, with two further cuts bringing rates to 3.50%. Beyond developed markets, emerging market central banks have embarked on their own easing paths, and we expect them to continue cutting rates in 2026.

The Bank of Japan remains the notable exception: the BoJ has initiated tightening at a pace materially slower than required for an economy running well above potential, with inflation persistently above target. We forecast two incremental 0.25% hikes in 2026, to 1.25%. As Japanese rates rise, Japanese investors who have massively exported capital for decades face a repatriation decision. This process will be gradual, since many investors keep bonds until maturity, and some investors (like hedged funds) will continue to invest internationally and seek FX risk, limiting significant repatriation flows to Japan. So, only investors who have hedged currency risk (banks, insurers, and pension funds) will be tempted to repatriate capital to reinvest in yen at elevated yields.

Lower rates create a support for emerging market local bonds: we forecast EM policy rates will decline, providing a monetary tailwind. Additionally, FX valuations appear attractive against the dollar, with us forecasting EM currency appreciation through 2026. Income remains compelling, at approximately 6% across the asset class. Fundamentals have improved materially, with several countries demonstrating enhanced fiscal discipline and supporting local debt sustainability. International investors remain underweight relative to historical allocations, creating potential room for significant inflows. We maintain a Positive stance on emerging market local bonds, though EUR-based investors should consider appropriate currency hedges.

Topics in Focus

A step too far against the Fed independence

Under attack: The Fed's independence is facing unprecedented threats from the Trump administration. The attempted removal of Lisa Cook, a Fed governor, on dubious allegations of mortgage fraud sets a disturbing precedent. The Supreme Court hearing will be on 21 January, with a decision expected in June-July.

Outrage and backlash: A criminal investigation into Chairman Powell's testimony on the Fed building renovation has sparked widespread outrage and condemnation from politicians and central bankers worldwide. This move appears to be Trump's way of signalling to Powell and his successor that he expects compliance with his views on policy rates, and that those who disagree may face consequences.

Market implications: Fitch Ratings has warned that Fed independence is crucial for the US sovereign rating. Whilst markets have remained calm, with long-term inflation expectations and the 10-year term premium unchanged, the implications of this assault on the Fed's autonomy are far-reaching and warrant close attention.

Agency MBS: A compelling alternative to USD investment grade credit

Attractive alternative to USD IG credit: Agency mortgage-backed securities offer yields comparable to USD investment grade corporates whilst presenting a superior risk profile and carrying implicit government guarantee. Current coupon MBS yield 4.7% versus IG corporates at 4.8%, with MBS duration at just 5.5 years compared to 6.9 years for corporates. This lower duration provides meaningful protection should yields rise whilst maintaining attractive income. From a valuation perspective, IG spreads are at the lowest in 20 years (0th percentile), whilst MBS spreads sit at the 7th percentile, offering better relative value.

Technical support builds: The MBS market benefits from President Trump's directive to GSEs to purchase $200 billion in agency MBS, contrasting with the Fed's ongoing quantitative tightening at $20 billion monthly. Meanwhile, IG corporate bonds face supply pressures close to $2 trillion in 2026, driven by AI-related capital expenditure. 

2026 Top Conviction

Emerging Market Local Currency bonds: High yields meet improving fundamentals

Monetary policy tailwinds create carry opportunity:

Inflation in many EM economies has moderated significantly, giving central banks room to cut rates ahead of the Fed and creating an attractive carry and roll environment. With our policy targets, we expect more rate cuts than currently priced into markets for both 2026 and 2027. Colombia, Brazil, and Turkey's central banks stand out as having more cutting potential, in our view. The JPM GBI-EM index currently yields around 6%, whilst real yields remain well above developed market equivalents, providing attractive income and a cushion against volatility.

FX valuations attractive against the dollar: We expect the dollar to weaken over our 12-month horizon, making EM currencies an attractive prospect.

Many EM currencies are undervalued relative to fundamentals, offering potential for appreciation and an additional source of return beyond the carry component. While euro-based investors may want to consider hedging due to expected depreciation, USD investors can benefit from potential appreciation, enhancing total returns. In our view, Eastern European countries offer the most significant upside against the USD

Stronger fundamentals: Several EM countries have taken steps to consolidate budgets and improve policy credibility. Debt-to-GDP ratios are under 60%, notably lower than the over 110% seen in advanced economies. There have been no defaults in 2025, for the second year in a row. In our view, Middle Eastern countries have the best fundamentals. This fiscal discipline has created a more stable investment environment than in previous EM cycles.

Technical support from under-ownership: International investors remain underweight EM local bonds compared to historical allocations, leaving room for further inflows. Thailand, Malaysia, and Egypt are the most under-owned by funds and ETFs. Growing domestic institutional ownership from pension funds creates additional support. In addition, EM local bonds offer low correlation to US Treasuries, providing portfolio diversification.