2. Trough interest rates in advanced economies; opportunities in emerging markets

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2. Trough interest rates in advanced economies; opportunities in emerging markets

Global economics and policy trends

2. Trough interest rates in advanced economies; opportunities in emerging markets

What we said
We expected policy rates in advanced economies to trough in the first half of 2026, with limited room for cuts given that rates were already close to neutral – the level that neither stimulates nor restrains growth. At the same time, high real interest rates in select emerging markets, notably Brazil and Mexico, were expected to create attractive bond opportunities.

How it has played out
The trough in advanced‑economy policy rates has materialised broadly as anticipated. However, the Middle East conflict has significantly complicated the monetary policy environment.

United States:
Markets are currently pricing a small probability of a rate hike in 2026, despite new Fed Chair Kevin Warsh signalling a preference for lower rates. This is due to the energy and commodity price shock associated with hostilities in the Middle East, something that has reignited inflation concerns and led to a repricing of rate expectations (Figure 2). Signs of dissent within the Federal Open Market Committee (FOMC) provide a salutary reminder that the Fed is not a dictatorship over which the Chair has ultimate control – Warsh will need to form a consensus and bring other FOMC members with him if he wants to ease the policy rate. That will be harder to achieve against the backdrop of the war.

United Kingdom:
The Bank of England had been expected to cut further, given a loosening labour market and subdued GDP growth. That trajectory is now on hold, with a high bar for cuts in the face of energy‑driven inflation pressures.

Switzerland:
The Swiss National Bank is expected to remain on hold throughout 2026, broadly in line with our earlier expectations.

Eurozone:
Higher energy prices have raised the prospect of rate increases by the European Central Bank, reversing earlier expectations of cuts.

Japan:
The Bank of Japan remains an outlier. With real rates still significantly negative, it is on course to raise rates by more than 1% over the next two years, keeping policy within its estimated neutral range.

On emerging markets, our call on high real rates in economies such as Brazil and Mexico was initially correct. However, repricing of global rates and higher inflation expectations following the outbreak of war in the Middle East have made the near‑term outlook for EM bonds more challenging. Over the longer term, we still expect strong fundamentals to support these markets.

Outlook for H2 2026
The path of rates in the second half of 2026 will be heavily shaped by developments in the Middle East. Our core view is that the Strait of Hormuz will reopen in the third quarter, allowing oil and other commodity prices to retreat, though an elevated risk premium is likely to those prices above pre‑war levels. The key risk is that the energy shock proves more persistent and feeds through more broadly into prices, forcing central banks to tighten policy rather than ease.

Action for investors:

  • Dial back EM bond exposure near term: Emerging market bonds look less attractive relative to when we made our original call, given greater uncertainty around rate policy amid inflation shocks.
  • Pivot towards developed market government bonds: We see better risk‑reward in developed market sovereigns, where markets appear to have overshot and overpriced the number of potential rate hikes.

2. Trough interest rates in advanced economies; opportunities in emerging markets

Policy interest rates are unlikely to fall much further in the main advanced economies in 2026, with a trough in rates expected during the first half. Elevated rates in several emerging economies are set to provide opportunities.

What are trough interest rates?
In economics, a “trough” is the lowest point in a business or economic cycle, following a decline and before a recovery. Trough interest rates occur when central banks have reduced rates to their lowest levels, often in response to economic downturns or recessions. The aim is usually to stimulate borrowing, investment and spending to help the economy recover.

Developed market rates
In all the major advanced economies, the scope for cutting interest rates in 2026 is limited. Policy rates are already close to what is considered the “neutral” rate – the level that neither stimulates nor restrains economic growth (Figure 2). Therefore, interest rates are likely to reach their lowest point (the “trough”) in the first half of 2026, after which further cuts are unlikely.

The Bank of Japan is expected to struggle to raise rates – at least until the middle of 2026. In Switzerland, rates are already at zero and Swiss National Bank President Schlegel has signalled the bar for reintroducing negative interest rates is higher than in the past. In the eurozone, interest rates are already close to neutral. The scope for UK rate cuts will be constrained by relatively sticky, above-target inflation, notably in the services sector. In the US, the range of estimated neutral rates remains hotly disputed but we doubt the Federal Reserve will reduce rates much below 3%, given strong real growth and inflation which is still sticky.

For those with memories of interest rates being at or close to zero in the recent past, such expectations will be disappointing. Very low interest rates would only make sense in the event of either a crisis situation, which hopefully is avoided in 2026, or one in which growth and the labour market are persistently weak, which we do not expect. On balance, we welcome the move to such neutral/trough rates as an indication that financial markets are behaving in a rational manner.

Politicised rate cuts
There remains, of course, the big question surrounding whether US Federal Reserve decisions become more politicised, with pressure for a large cut even if inflation remains above target and growth and unemployment remain resilient. On balance, we see the risk of that as small. It is not reflected in current market pricing, such as inflation break-even rates, or the expectations of current Fed board members.

If it did happen the central bank could well fail to achieve the apparent political objective of lower borrowing costs for households and businesses. A politicised cut in rates would likely raise longer-term interest rates (reflecting a higher risk premium and higher long-term inflation expectations) therefore negating the impact.
 
Opportunities in emerging economies
In several emerging and developing economies, real interest rates are particularly high when measured on the simple basis of comparing the policy interest rate to the latest inflation rate (Figure 3).

In these economies, it is important to consider two key factors. First, the risk that currency depreciation may offset the advantages of higher interest rates for investors. Second, the likelihood that inflation may not remain subdued could potentially affect real returns. In a general environment of a stable-to-weakening US dollar, the first risk seems contained for 2026. But the fact that the inflation-fighting credentials of many emerging economy central banks have yet to be fully established is a concern. On balance, we think these two risks are lowest in Brazil and favour money and bond market exposure in that market compared to other emerging market peers.

In Brazil, ten-year local currency bond yields are as high as 13.7%5, well in excess of the likely 4.0–4.5% inflation rate for 2026 and also above expected longer-run inflation trends. Brazil, however, may remain overshadowed by political tensions with the US.

In contrast, Mexico is likely to experience a greater boost to growth from a stronger US economy, which should also help support the peso. Additionally, since Mexico’s interest rates are closely aligned with those of the US, they are expected to follow any rate reductions.

Action for investors:

  • With interest rates expected to reach neutral, trough levels in the first half of 2026, there remains value in shorter- to mid-term duration exposure. This environment allows investors to borrow at the short end of the yield curve and invest further out to capture attractive carry opportunities.
  • Real rates in some emerging and developing economies remain elevated and provide opportunities but investors need to be wary of the risk of currency depreciation.
  • Look for opportunities in high-yielding emerging sovereign markets where there is the prospect of capital gains as long-term yields decline. Brazil, most notably, has high real yields in a slowing economic environment.
  • Mexico is set to be a beneficiary of a stronger US economy, which should support the Mexican peso.

5 Source: LSEG as at 03 October 2025.

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