Fed set to chop rates of interest: Here’s why central banks may begin HIKING once more subsequent yr

The Federal Reserve is set to cut US interest rates later today, followed by an identical move from the Bank of England next week.

However, a busy end to the year for monetary policy comes as investors begin to reprice expectations for other central banks, setting the scene for what some analysts think could become the dominant market theme of 2026 – the diversion of global interest rates.

The rate cutting cycle may have already come to an end in some major economies and other central banks look set for rate hikes in 2026, creating the conditions for potential upheaval in financial markets.

Investors have priced in a hawkish 25 basis point Fed rate cut later today, taking its target range to between 3.75 and 4 per cent.

Investors will be keeping a close eye on Fed commentary and the number of Federal Open Market Committee members who do not back the move for clues as to how many more rate cuts will be delivered next year.

It comes as the Fed, which has continued to face pressure from the White House to cut rates, contends with above-target inflation and evidence that the US jobs market is under increasing pressure.

Investment bank ING expects four votes for a no-change decision, up from just one in the Fed’s last meeting, which could weigh on current forecasts for two more rate cuts next year.

Global head of markets Chris Turner said: ‘Clearly, the pricing of a second rate cut in 2026 is at risk today and comes during a week when investors are hawkishly reassessing global central bank policy.’

However, should President Donald Trump get his way in re-shaping the Fed and its leadership, US rate cuts will become more likely.

Similarly, investors still expect the BoE to pull the trigger on three more rate cuts of 25bps each starting next week, taking base rate from its current level of 4 to 3.25 per cent by next summer, despite inflation being well above its 2 per cent target.

It comes as investors are increasingly reassessing expectations for interest rates in other major economies.

Bets on European Central Bank rate hikes next year are growing, even though eurozone inflation is currently well below that of the US and UK at 2.1 per cent.

Investors also think the Australia Reserve Bank and the Bank of Canada will hike rates next year as their economies show better than expected growth.

Analysts at UBS believe the Fed still has room to move lower. 

They wrote in a note: ‘Markets are indeed pricing Fed cuts at a time when other central banks are expected to hike, but most of these central banks have already cut rates to or below neutral levels.

‘Conversely, Fed policy is still above the estimated 3 per cent neutral point and is projected to end 2026 slightly above there. Markets might anticipate further easing, but it is hard to argue that they are pricing a very dovish outlook.’

Market implications  

Diversion in global monetary policy has implications for economics and financial markets.

Countries with higher interest rates typically see their currency’s value rise relative to those with lower rates. Relatively lower rates can therefore boost exports, but they can also make importing goods more expensive.

And while lower borrowing costs are typically bullish for economic growth and stock valuations, higher rates compared to other nations can attract global investors with higher yields on their capital.

Divergence can also complicate cross-border funding and increase volatility in global credit markets.

Neil Wilson, UK investor strategist at Saxo Markets, said: ‘If [other central banks] are hiking with the Fed “running it hot” next year with a couple more cuts then we should expect further dollar weakness, which could be good for risk assets even if bond yields are rising.

‘However, the hawkishness we are starting to sense will almost certainly be echoed in a hawkish cut by the Fed.’

Bond vigilantes watching closely

In the short term, however, the prospect of diverging global rates spells trouble for the UK and other western countries attempting to get their fiscal affairs in order.

Global government bond yields – the interest countries pay on their debt – have been rising over the last week to reflect the prospect of high rates, even in markets where monetary policy is expected to ease further.

The yield on German 10-year bunds hit its highest in nine months this week, while Australian yields of the same duration hit their highest in over a year.

Meanwhile 10-year gilt yields were up by another 3bps on Wednesday, meaning they have added 8bps over the last month – the same as 10-year US Treasury yields.

Matt Dever, head of advisor solutions at Brandywine Asset Management, said: ‘Looser Fed policy at the current time is detrimental to the long-term health of the US economy, and equity and bond markets.

‘Lower short-term rates will only steepen the yield curve and drive-up longer-term rates, the ones that really matter.

‘This is because, bond “vigilantes”, while currently suppressed, are real. They will demand higher bond yields if they fear rising inflation and currency devaluation due to lower short-term rates.

‘While short-term interest rates may move lower, the rates that count, such as 10-year and longer, which are used as the basis for mortgages, will rise.

‘Lower short-term rates are not a panacea. They are a problem.

‘Batten the hatches. Once we start to bring on water, the flood will be hard to stop.’