Bond Watch: what rate hikes mean for investors

For much of the past two years, the fixed income story has centred on when and how quickly central banks would cut interest rates. 

With the exception of the idiosyncratic Bank of Japan, developed market central banks spent 2024 and 2025 gradually reducing rates. 

Now in 2026, the scene has changed. Foreshadowing the Fed’s decision this week, the European Central Bank (ECB), following its first upwards movement in June, again raised its deposit rate (the ECB’s main policy rate) by 25 basis points to 2.5% earlier in September, citing upwards revisions to growth but, crucially, persisting above target inflation.

Sure enough, this week the US Fed has followed suit and raised rates – the first hike in three years. 

Meanwhile, the Bank of England has held but delivered a decidedly hawkish message, leaving the door open to rate hikes before 2027. 

While the regions wrangle with their own unique circumstances, a prevailing threat all three central banks hope to tackle pervades: the risks of sticky inflation owing to elevated energy prices driven by international conflicts. 

While Japan possesses a very different inflationary dynamic to Europe and the US, the decision today to raise the main interest rate from 1% to 1.25% also reflected the price pressure associated with the war in Iran.

Let’s take a closer look at this week’s US and UK decisions and what this means for investors.

The Fed begins to hike once more

On Wednesday the Federal Open Market Committee (FOMC) voted to raise the US policy rate 25 basis points to 3.75-4%. 

Despite geopolitical uncertainty, economic activity, investment and consumer spending remain robust while job openings are increasing and joblessness remains low. 

However, inflation remains high and the hike centres on the issue of price stability. August CPI rose 0.4% month-on-month and 3.4% year-on-year. The US has suffered now five years of above-target inflation.

Amidst his appointment as Fed Chair, some might have feared that Kevin Warsh would attempt to deliver President Trump’s ideal monetary policy – a policy rate of 1% or less. 

However, citing the absence of meaningful progress in recent inflation figures across the board and supported unanimously by the FOMC members, the first change to the policy rate under the new Federal Reserve Chair is upwards.

This decision was met with an orderly market reaction on the day. 

In part, this is because of the strong market consensus in prior days anticipating this tightening with 90%+ certainty. 

On top of that, the news that the world’s largest economy is growing, providing jobs and showing some consumer resilience of course also has positive implications – not least in diminishing the stagflationary concerns threatening the longer-term fiscal position. 

The US 10-year treasury yield (which has pushed upwards in the months prior) flitted above 5% before falling bac­k to lower levels and very long-term treasury yields softened. 

US equities (S&P 500) rose by 0.7% (in USD terms). Tech companies (as discussed last month) might now be a degree more reliant on borrowing, but investors have seen US companies’ valuations expand and earnings grow amid far higher policy rates in the past few years.

Over the long term, more thought-provoking for investors than the 25 basis point hike itself is the idea that this may not be a one-off move. 

Warsh will not describe current financial conditions as restrictive – rather implying interest rates were too low and hence “we have removed an element of accommodation”. 

While Warsh won’t be feeding into projections himself, those of the other FOMC members indicate further tightening coming this year, and the futures market reflects this view. 

While higher short-term borrowing costs can be a drag for corporations and US mortgage buyers will feel the difference, the sense from the Fed is that the American business and consumer can take it.

The Bank of England’s hawkish hold

The Bank of England left rates unchanged the next day at 3.75% - also not bucking expectations. 

The tone of the meeting, however, was decidedly hawkish and three of the nine members voted in favour of a hike. 

But the decision was caveated with a firm commitment to identifying and responding to any evidence of second-round inflationary effects from the Middle East conflict, and conceded a well above-target August 12-month CPI reading of 3.1%, which is anticipated to rise into year end.

There’s now a very real probability of rate hikes in the UK before the year is out, and this likelihood rises with each continued month of disruption to energy infrastructure and supply spurred by the continuation of the US/Iran conflict.

Yet the unchanged policy rate was not the only substantial decision. 

The Monetary Policy Committee (MPC) unanimously determined to alter the Bank’s quantitative tightening strategy, by (amongst other measures) electing to sell £20 billion annually of government bonds (alongside natural maturation) to gradually and predictably reduce the stock of government bonds held for monetary policy purposes. 

Given that gilts maturing after 2049 won’t be included in this sale, longer-date bond prices reacted positively (and yields fell) as this reduces a structural selling pressure from the long end. 

This may provide a meaningful technical tailwind for downtrodden longer-dated gilts, although the direction of yields will ultimately remain dominated by long-term inflation, growth and fiscal expectations.

Forecasts and projections in an uncertain world

With so much hinging on the trajectory of energy prices, which will be largely determined by the practically unforecastable outcomes of the conflicts in both Iran and Ukraine, investors and central bankers alike must concede a degree of futility in predicting the next inflationary and therefore policy developments.  

We might share Warsh’s own scepticism regarding what he deemed the “hall-of-mirrors problem” per his keynote remarks at Jackson Hole – the distortions abounding from markets looking to the Fed for guidance while the Fed makes its own conclusions from market pricing. 

That view is reflected in his own decision not to submit his projection into the Fed dot plot.

For bond investors, renewed uncertainty over the path of interest rates strengthens the case for caution around taking substantial duration risk (or sensitivity to interest rate changes). 

As things stand, further Fed hikes are likely though the quantum is unclear. 

Most FOMC participants are expecting at least one more this year and the market projects somewhere between 0 and 75bps of hikes by January 2027 (FedWatch - CME Group). 

We can assume the story for the Bank of England could be similar if elevated energy prices persist and begin to feed into wages and wider price-setting.

That makes aggressive duration exposure harder to justify while attractive yields remain available at the shorter end of the curve for government and investment-grade bonds, where price sensitivity to changing rate expectations is far lower. 

Longer-duration bonds could ultimately benefit strongly if inflation subsides in a manner not foreseen by central bankers or market participant, but for now investors are being paid reasonably well to wait for greater clarity.