The last 2 times in the first half! The market lowers "the expectation of the Federal Reserve's interest rate cuts next year," will 2026 become the "policy turning point" for global central banks?

The market is reducing bets on significant interest rate cuts by the Federal Reserve next year, while major central banks such as the European Central Bank and the Bank of Canada are facing expectations of rate hikes. This trend of policy divergence may reshape the global monetary policy landscape in 2026.

According to Bloomberg on Wednesday, in addition to a 25 basis point cut this Wednesday, traders currently expect the Federal Reserve to only cut rates by 50 basis points in 2026, mainly concentrated in the first half of next year, after which rate cuts may pause. This represents a significant narrowing from the market's expectation of three rate cuts a week ago.

Charlie McElligott from Nomura Securities pointed out that Hassett is seen as a supporter of Trump's growth-promoting "hot economy" policy. Coupled with the upcoming fiscal stimulus and corporate earnings growth exceeding expectations, these positive factors may exacerbate the risk of persistent inflation, thereby weakening the path for deep rate cuts by the Federal Reserve.

Meanwhile, swap market pricing shows that the likelihood of rate hikes by the European Central Bank in 2026 has surpassed expectations for rate cuts, with similar policy expectation shifts occurring in Australia, New Zealand, Canada, and the Eurozone. The dollar has already fallen more than 8% this year, and policy divergence may further exacerbate the dollar's decline.

Traders Adjust Federal Reserve Rate Cut Expectations

Interest rate futures and options trading show a sharp shift in market expectations for the Federal Reserve's rate cut path in 2026. Futures contracts linked to the Secured Overnight Financing Rate (SOFR) indicate that the spread between the December 2025 and December 2026 contracts has reached the smallest negative value since June, reflecting a significant narrowing of the expected rate cut magnitude.

SOFR options flows have recently skewed heavily towards dovish hedges, but the focus is mainly on the first half of next year, indicating that traders are hedging against the scenario where the Federal Reserve pauses after ending its rate cut cycle in mid-next year.

A survey by JPMorgan for the week of December 8 shows that Treasury bond investors continue to close long positions and shift to a neutral stance. The benchmark 10-year U.S. Treasury yield is currently at its highest level since September, and bullish momentum has faded.

Lauren Goodwin, Chief Market Strategist at New York Life Investments, stated that in the context of persistent inflationary pressures, significant rate cuts may call into question the Federal Reserve's credibility in combating inflation. She believes that a rate hike by the Federal Reserve in 2026 "is absolutely a risk," although it is not her baseline scenario.

Inflation Risks Will Reshape Federal Reserve Policy Path

Nomura Securities analyst Charlie McElligott noted in a recent report that the market expects Hassett to support Trump's growth-promoting "hot economy" policy while advocating for a weaker dollar. Coupled with the upcoming fiscal stimulus measures and widespread upward surprises in corporate earnings and revenue growth, these combined positive factors and a loose financial environment may exacerbate the risk of "stickier" inflation.

McElligott specifically mentioned that when inflation exceeds 3.5%, gold rather than bonds will become the hedge against stocks, and this environment will weaken previous expectations for a "deeper" rate cut path by the Federal Reserve. The market will closely monitor the Federal Reserve's guidance on next year's policy path from its meeting this Wednesday, as well as the November employment data to be released on December 16 and the December employment report on January 9. These data will provide key references before the Federal Reserve's next policy meeting on January 28.

Rare Divergence in Global Central Bank Policies

In stark contrast to the expected rate cuts by the Federal Reserve, several major economies' central banks are facing expectations of rate hikes. Swap market pricing indicates that the European Central Bank's likelihood of raising rates in 2026 has now surpassed that of cutting rates, while the Federal Reserve is expected to cut rates at least two more times next year.

Investors are also betting that Australia and Canada will raise rates next year, while the Bank of England is expected to hit a low in the summer of next year. Part of this policy divergence is due to the impact of the Trump trade war on U.S. trading partners being less severe than expected.

This policy divergence could exacerbate the dollar's decline. So far this year, the dollar has fallen over 8% against a basket of currencies. Typically lower interest rate regions like the Eurozone and other major economies are now facing a policy shift, which may further narrow the interest rate differential with the United States.

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