Tightening again

Tightening again

Markets are pricing higher official interest rates. This week, the European Central Bank raised its key policy rates by 25 basis points, taking the main deposit rate to 2.5%. Current pricing implies at least one hike from the Federal Reserve, another from the European Central Bank, and close to two from the Bank of England.

Whether all of these, or even more, will be delivered remains to be seen. But markets are nervous. Oil prices topped $100 per barrel again this week, with the Middle East situation as intractable as ever. 

This is the key reason markets have little confidence that inflation will move back to central bank targets anytime soon. Indeed, inflation swap rates have been rising since August. Not that long-term inflation expectations are being seriously dislodged, but market action points to central banks having to raise rates to meet the risk of inflation rising again.

It is the rates that kill you

All of this has hit bond total return performance again. So far in September, the numbers make disappointing reading. The ICE Global Aggregate Bond index has a month-to-date total return of -0.9% as of 10 September. Third quarter returns are -1.3% so far and for 2026 to date, the performance is -0.6%. 

Readers will know I have long preferred high yield. The numbers warrant that confidence. US and European high yield indices’ total returns are just either side of 2.0% in 2026 so far. 

A more specialist asset class, convertible bonds, has done much better because of attractive yields and rising equity markets. An indicative global index puts returns at 14% in 2026.

Real corporate profits drive outstanding outperformance

This highlights the year’s key story. Equity market outperformance has been staggering. Since the end of 2023, the MSCI World Index has a total return of around 62%. The global aggregate bond index has managed about 4%. This is against a backdrop of inflation being higher than central bank targets. 

But if your equity earnings are growing by 20% per year, or more in the case of companies in the artificial intelligence world, why do you care? Inflation is not that high, and to be fair, much of it is coming from geopolitical shocks. 

It is enough to keep central banks on edge, and, for the longer end of the bond market, there are fiscal concerns. Hence the ongoing reset of long-term bond yields. 

Real yields up as the world invests in AI

The world has moved away from the decade-plus period when the challenge was to prevent inflation being too low (thereby exacerbating the balance sheet disaster that resulted from the global financial crisis at the end of the 2000s). 

Since the pandemic, the challenge has reversed. Going forward, the AI productivity boost should help, but for every little bit less of an inflation premium in bond yields, there is likely to be a little bit more real yield.

Indeed, we are seeing that. Real bond yields have been rising steadily over the last year. In the US, 10-year real yields are above 2.5% – again, back in pre-global financial crisis territory. 

The adjustment to higher yields is painful for existing holders of long-duration bonds and will be painful for finance ministers who need to refinance debt at higher coupons than we have seen for some time. 

But for someone with a 40-year career in financial markets, the levels are not that high, really.

Too many fears

The short term looks difficult for markets. Global growth seems fine – even the UK is seeing an acceleration in activity and improvements in the labour market. But the geopolitical situation is tense with clear risks to inflation, and potentially, for consumer and business confidence. 

Then we have the US and upcoming Congressional elections that will test faith in that country’s political system.

I have often referred to trend growth in nominal GDP as a guide to where long-term government bond yields should be. For years, yields were below “normal” GDP growth. Today, the relationship has been restored. Real yields are higher, because of shifts in savings/investment balances encouraged by high prospective returns that are driven by increased productivity. Add to that, inflation that seems likely to remain just on the wrong side of central bank targets and you have 10-year bond yields that, in the US, should be looking at 5%, as they have already done so in the UK. 

To stop them overshooting needs policy credibility. As such, we should be prepared for a round of central bank tightening (I doubt we will exceed the 2023 peak in rates which, I would point out, did not result in a global recession). 

As important, for bond and equity markets, is credibility on the fiscal side. I am less confident about that. Hence the US mid-terms and next month’s UK Budget remain two of the most notable events on the markets’ timetable. 

I said previously that bonds are attractive given current yields. Yields are higher than they were two weeks ago when I last published. The same sentiment holds. Newly issued bonds with attractive coupons are a much better bet than bonds that were issued with extremely low coupons a few years ago (from a prospective price volatility point of view). 

But the noise around bonds will remain negative while the dream of a world made better by AI will keep equities outperforming. Other scenarios are available, but betting on them now does not seem to be sensible.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, BNP Paribas AM, as of 10 September 2026, unless otherwise stated). Past performance should not be seen as a guide to future returns.