Investors have increased bets that interest rates in the euro zone could rise next year even as the US continues to lower borrowing costs, in a shift that could further weigh on an already weak dollar.
Swap markets pricing now implies that the European Central Bank (ECB) is more likely to increase rates in 2026 than cut them.
By contrast, the US Federal Reserve, which is generally considered all but certain to lower borrowing costs at its next meeting on Wednesday, is expected to make at least two further cuts next year.
Investors are also betting that Australia and Canada will increase rates next year as their economies improve, while the Bank of England (BoE) is widely expected to reach the bottom of its cutting cycle by next summer.
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Pooja Kumra at TD Securities described next year as a potential “turning point” for central banks in the euro zone, Canada and Australia, adding: “Hawks are being more vocal.”
While the shift is likely to bring the US and other countries’ interest rates closer together, the contrasting directions of travel on borrowing costs could add to a decline in the dollar, which has already fallen more than 8 per cent against a basket of other currencies this year.
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Lower interest rates typically reduce the attractiveness of holding a currency for investors as well as reducing governments’ borrowing costs.
Interest rates are currently lower in the euro zone and several other major economies than in the US — partly because of their slower growth.
But policymakers in the ECB and other central banks may be unlikely to lower them further to jump-start growth, since Trump’s trade war has proven to be less damaging to US trading partners than previously thought.
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Swap market prices currently imply on average a rise of 0.06 percentage points in the Eurozone by the end of next year. By contrast, at the end of last week, they indicated a 0.04 percentage point cut.
The “global tariff shock has turned out to be a lot more benign than originally anticipated”, said Tomasz Wieladek, chief European macro strategist at asset manager T Rowe Price. “Central banks around the world are gradually becoming more hawkish.”
Bloomberg on Monday reported remarks from ECB board member Isabel Schnabel that she was “rather comfortable” with investor bets on a euro zone rate increase next year.
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The hawkish shift helped to push up global bond yields on Monday, with the German 10-year Bund yield jumping 0.07 percentage points to 2.87 per cent, while there were similar moves in other European bond markets. The 10-year Bund yield fell back 0.02 percentage points on Tuesday morning.
Investors will be keenly watching this week’s Fed meeting for any signal about its future intentions. The central bank has come under sustained pressure from President Donald Trump to lower borrowing costs.
“Assuming that the Federal Reserve stays in dovish mode ... a turn in the policy rate cycles overseas should be another factor contributing to a mildly weaker dollar in 2026,” said ING’s Chris Turner.
The dollar was down 0.1 per cent against a basket of major currencies on Tuesday.
Better than expected economic data has combined with pockets of inflation, such as elevated services inflation in the euro area, to erode the case for further rate cuts.
Strong November jobs data in Canada has prompted traders to ascribe a small chance of a rate rise that could come early next year.
Markets are also pricing in a small possibility of a February rate increase by the Reserve Bank of Australia, after robust household spending data last week. The RBA signalled a “more broadly based pick-up in inflation” as it left rates unchanged on Tuesday.
In Japan, which has been raising rates since last year, traders are now pricing in at least two quarter-point increases by the end of 2026, after the latest hints from its central bank governor earlier this month.
Traders are expecting the BoE to cut rates by a quarter-point from the current 4 per cent at its meeting next week. But there is only one further quarter-point cut fully priced beyond that.
The Organisation for Economic Co-operation and Development (OECD) said last week it thinks BoE rate cuts will “cease in the first half of 2026” as one of several big economies whose interest rates it judged as close to their so-called neutral rate, a theoretical level that neither constrains nor boosts economic growth. – Copyright The Financial Times Limited 2025
