We need to talk about bonds
Donough Kilmurray
Chief Investment Officer
If we had known in January that 2026 would bring war in the Middle East, oil prices over $100, higher inflation, interest rates and bond yields going up instead of down, the United States Treasury Secretary fighting with bond markets, artificial intelligence (AI) models running amok, and equity valuations contracting, we would have feared a down year for stocks.
Yet here we are, with the major global indices up double digits (in US dollars) for the fourth year in a row, and earnings growth accelerating despite all the political noise and higher costs. If anything, it’s yet another reminder to ignore the noise and focus on the fundamentals. In this edition, we’ll sift through macroeconomic developments, in particular the rise in bond yields, and investigate their potential impact on investment returns. Our conclusion is more comfort with equities, some concerns for bonds, and a little discomfort with the US dollar.
Where it stops, nobody knows
Even allowing for the unpredictability of President Trump and his military adventures, the price of oil continues to confound experts this year. So much so that the commodity research team at JPMorgan wrote that they no longer have a baseline view on the Iran war or the oil price.¹ The wisdom back in March was that limited supplies of oil would force a resolution within a few months. As it turned out, some countries (like China) had larger reserves than expected, some managed their reserves more effectively, allowing higher prices to reduce demand, and, significantly, a lot more oil continues to flow from the Gulf than we realised.
Figure 1: Evolution of oil prices in 2026
Source: Bloomberg. Brent is the benchmark for European (North Sea) crude oil. “Brent Dec-26” means the contract for delivery of Brent crude in December 2026.
Of course, lower supplies have led to higher energy prices, higher inflation, higher interest rates and bond yields. Yet President Trump remains deaf to his MAGA base, surprisingly so given the mid-term elections, and the elevated Treasury bond yields which made him pause his tariffs last year have yet to change his mind this year. Our working assumption is that energy supplies will gradually improve and prices eventually come down. But the timing is unknowable, and so we expect prices to remain above pre-war levels, and for inflation to remain above target² for at least the next few quarters. We realise this sounds vague, but confidence or precision are simply not realistic.
From rate cuts to hikes
In January, we and most of the market expected to see central banks gradually cutting interest rates in 2026 as inflation cooled. Not the ECB (European Central Bank), where euro rates were down at 2% already, but we thought that US and UK rates would be closer to 3% by later in the year. How wrong we were.
Figure 2: Interest expectations now and earlier in 2026
Source: Bloomberg. Each dot represents a Federal Reserve meeting.
Source: Bloomberg. Each dot represents a European Central Bank meeting.
With Eurozone inflation over 3%, and the ECB’s history of prioritising price stability over growth, it shouldn’t be a surprise that euro rates are already up to 2.5%. The surprise has been the resilience of the energy-poor Eurozone economy, and given the ECB’s revised growth and inflation forecasts, a couple more quarter-point hikes look likely from here. The Bank of England (BOE) has a tougher call to make. Although UK unemployment is stable at around 5%, job growth and wage growth have both slowed down. The new chancellor has a very tricky budget to land this month, and higher borrowing costs will not help. So we expect the BOE to tread carefully, only hiking enough to maintain credibility, and likely less than is priced in. The US Federal Reserve (the Fed) is more confident. After confusing markets in his early press conferences with his minimalist approach to communication, new Fed Chair Kevin Warsh was clearer in August on his inclination to raise rates. Then in September, in defiance of President Trump, he hiked to 4%, and recent strength in US jobs likely means another hike or two.
Don’t fight the bond market
Energy prices made the headlines, and stocks made the returns, but the real market action this year has been in bonds. While short-term government yields are tethered to central bank interest rates, longer-term yields, which are set by the market, have recently reached levels not seen in 20 or 30 years. Are they just normalising, or should we be worried?
Figure 3: 10-year government bond yields
Source: Bloomberg. Each yield is quoted in the local currency.
Expectations of higher inflation and interest rates would naturally lift bond yields, but if we strip out expected inflation and look at the “real yield” we find that there is more to it than just rising prices. Fiscal hawks have long warned of a point when bond markets would tire of continual budget indiscipline, and it seems we may be approaching such a point. Now 2-3% real yields, or nominal yields over 5%, as we’ve just seen in the US and UK, are not on their own a catastrophe. In fact they’re not far off the long-term historical average. However when government debts are larger than their economies, the interest cost can become a serious problem, making it harder to balance a budget and avoid borrowing even more. Treasury Secretary Scott Bessent is well aware of this danger and has resorted to bond-buying tricks and telling the market it has gotten the economy and bond yields wrong. Unfortunately for him, the market was not impressed and yields went higher. Even his old boss, legendary investor Stanley Druckenmiller, came out and criticized him publicly³. “Governments defending prices against fundamentals always lose.”
How is this all resolved? Barring a Truss-style crisis⁴, Bessent’s current boss, President Trump, is unlikely to voluntarily tighten his fiscal belt, so as happened in the UK in 2022, the central bank may have to intervene. Fed chair Kevin Warsh is opposed to bailing out the government, but he has the only balance sheet big enough to do so and may eventually have to.
Figure 4: Government debt and interest costs
Source: IMF, UBS. Based on 2026 estimates.
Before we get too smug about US debt problems, the UK is facing a tough credibility test with its upcoming budget, and euro sovereign yields are already rising in anticipation of a populist government in France and further political weakness in Germany. Ultimately higher yields are likely to continue, with little near term prospect of fiscal balances improving meaningfully. Softer inflation and lower interest rates next year would help, but the risk remains that central banks will have to print money to buy bonds, which could lead to continued above-target inflation, which in turn would keep rates and yields high.
Bond yields vs the stock market
While bonds struggle with rising yields, equities seem less bothered. Is this complacency justified? The most obvious fear from higher yields is that they raise the cost of financing growth and can force governments into austerity. However, growth appears to be accelerating rather than slowing, and populism is still preventing fiscal prudence. The most obvious sector suffering from higher borrowing costs is construction, but aside from data centres, this activity is already in the doldrums in the US. AI infrastructure, the main engine of construction growth, is so heavily financed by the technology companies that local protesters may have more chance of slowing construction than bond yields. In theory, the value of a stock, or stock market, is the present value of all future dividends. Higher yields now mean that dividends in the future have less value in the present, which should reduce the valuation multiple on earnings. Higher growth sectors with more reward in the future should see their multiples hit by more.
Figure 5: Decline in equity valuation multiples
Source: MSCI. Using price to forward earnings as valuation multiple.
In fact, this has already happened. In the past 12 months, the price / earnings ratio for the US index has fallen by 18%, and the world technology index valuation has fallen by 31%. Normally we see drops like these in economic slowdowns, where they drag stock prices down, but earnings growth has been so strong that prices have continued to rise despite falling valuation ratios. There is another important consequence of higher bond yields. In the past, when yields were low, the correlation between stock and bond returns was low to negative, making bonds great diversifiers in portfolios. But when yields top 5%, as they have now, the correlation becomes more positive, and bonds are less effective risk-reducers in portfolios.
Figure 6: Bond-equity correlation vs US treasury bond yields
Source: Standard & Poors, Bloomberg. Using 10-year treasury yield and correlation between the S&P 500 and US Treasury Aggregate indices.
Lastly, asset allocation is all relative, and assets compete with each other for investor capital. While euro options are less attractive, a risk is that cash yields of 4% and bond yields over 5% may lead US and UK investors to divest from stocks. However, to date fund flows indicate that most buyers still prefer equity growth over bonds.
Dollar doubts again
Early last year, as the new Trump administration’s policies emerged, the dollar went into a tailspin, depreciating by over 10% versus its major trading partners in a few months. On top of the fiscal extravagance and the trade war, there were threats to make foreigners pay to invest in the US, and for the first time in years, they became net sellers of US financial assets. Of course, we know what happened next. US stocks slumped, US bond yields spiked, and Trump backed down on his more severe threats. Confidence returned, and capital flows resumed as the world bought back into higher yielding US bonds and higher growth in US stocks. These flows helped reverse the dollar’s decline, keeping it within a more stable trading range during the second half of the year.
Figure 7: The US dollar index in 2025-26
Source: Bloomberg. The dollar index is based on a weighted basket of US trade partners.
Roll forward to late 2026. As bond markets lose patience with US fiscal incontinence, and roll their eyes at Bessent’s attempts to stop yields rising, we move closer to the Fed having to print dollars to buy treasury bonds. Fed chair Warsh does not want to dilute the US currency like this, but it may become the only viable option to keep borrowing costs under control. To hedge against this risk, we recently began to reduce dollar exposure in portfolios, as we did in early 2025, but by a smaller amount this time. So far the move has not worked, as the Fed’s hawkish stance on raising US interest rates has strengthened the dollar, but we still believe some caution on the dollar is warranted.
Gold to shine again
Most of the fears hanging over the US dollar – deficits, debts, interest burdens, inflation – could also apply to other major currencies. And as populist politics spread across Europe, we could see the ECB and BOE having to intervene in their local bond markets too, raising the risk of continued above-target inflation. Gold-bugs and bitcoin fans will recognise this as a classic currency debasement scenario, for which their favourite asset, with its finite supply, is the natural solution. We are by no means “fiat currency doomers⁵”, but we do think that gold may have a useful role to play in portfolios. Critics of the metal rightly point out that its price has more than doubled this decade, and that it actually fell by more than 10% in March when the US and Israel attacked Iran, the very type of situation where it is expected to rally. Has gold lost its lustre?
Figure 8: Sources of gold demand
Source: World Gold Council. Investment can either be in physical form (bars & coins) or exchange-products (ETFs).
As with any commodity, it’s all about supply and demand. Gold supply grows very slowly, so demand drives the price. After western banks froze Russian assets in 2022, other central banks diversified more into gold. The resulting price surge attracted retail investment, which pushed it up even faster, and traditional buyers stepped back as speculators piled in. See Figure 8. When markets wobbled earlier this year, these short-term buyers cut their risk and sold much of their gold. Central banks have made clear their intention to continue diversifying their reserves, and as traditional buyers return, we expect gold behaviour to revert to historical patterns – not a reliable hedge against market volatility, more a hedge against currency debasement. Another route we have taken recently is to invest in gold miner stocks. Although energy prices have pushed up their costs, with the gold price over $4,000 their profit margins are enormous, and their valuations still modest. While they have used recent earnings to bolster their balance sheets, we caution that these stocks are still very volatile and positions should be small.
Wild cards Although the global economy and markets have weathered the surprises of the year so far, there are still plenty of event risks on investors’ minds. An obvious one is the US mid-term elections, where Republicans are expected to lose control of the House and maybe the Senate too. Mid-term elections usually go against incumbent parties, and with President Trump’s poll numbers, a Democrat sweep would not be a surprise. Apart from slightly higher volatility, mid-terms are usually non-events for markets, with no reliable return patterns. A Democrat sweep would raise fears of more tax and regulation, for the technology sector especially, but this is more likely under the next president. The most likely, and the market’s preferred outcome, is 2 years of gridlock and no meaningful new legislation. A real wild card is an AI safety crisis. If targeted or uncontrolled agents were to hijack the financial system or military facilities, this could cause mass panic in markets. While we’re not so naïve to say that it could never happen, we don’t know what form it would take, how to trade it, or if we would even be able to. It seems more like a survival issue than an investment issue.
Investment conclusions We have no idea when the war in Iran is resolved or when energy prices subside, so we expect inflation to remain above the official 2% target. It has already averaged close to 3% for the past three years now and hasn’t prevented solid growth, so we’re not panicking, but the uncertainty around future inflation is beginning to have an impact on markets. While the Bank of England is being more cautious, the Federal Reserve and European Central Bank are comfortable enough with their growth outlooks to already have raised rates. Although we think markets may be over-pricing rate hikes for next year, we do expect 1-2 one quarter percent hikes from all three banks in coming quarters. As for bonds, given the level of inflation and inflation uncertainty, and the state of government finances, we believe that yields will stay high. But if yields rise too far or too fast, we expect central banks will intervene to prevent a crisis. Although the Fed’s tougher interest rate stance has strengthened the dollar, US fiscal weakness and potential intervention in the treasury bond market should weigh on the currency. Central banks bailing out profligate governments may be more widespread, and we hold gold as a hedge against this scenario. As for equities, higher bond yields have hit valuation ratios, but earnings growth has been so strong that returns are still healthy. Encouragingly this is no longer just a technology story, with energy, financials and other cyclicals doing well too. But technology earnings forecasts are so strong, in the US and Asia, that there is growing room for disappointment there. Overall, we are comfortable staying invested with the economy in such good shape. But being mindful of the excesses leads us to lean away from areas with aggressive expectations, like the technology sector, or stubborn imbalances, like the US dollar. And as always with the current US president, we stay balanced and diversified to withstand the unexpected.
Figure 9: Current positioning for Euro Moderate Growth Potfolio
Note that each box represents 0.5% of the overall portfolio. The blue circle indicates the tactical under-over-weight at the overall asset class level. *The tactical equity allocation means that there is a further 3.5% underweight to US dollars.
Portfolio changes in Q3 2026* 1. In early July, we reduced our overweight to emerging market equities, which had been funded by an underweight in global developed equities. The performance of semiconductor companies in Korea and Taiwan had been so strong that we viewed it prudent to trim the exposure. 2. Rather than return the capital to the developed index, which is dominated by the US tech sector, we instead re-allocated it to Indian equities. This high growth index has lagged in recent years as investors chased AI stocks. We liked the improved valuation, the potential for high non-AI growth, and the upswing potential from the resumption of inward capital flows. 3. In August, we initiated an allocation to gold miner stocks. We viewed their enormous profit margins, their improved balance sheets, and their modest valuation as another way to build exposure to gold. Due to their high volatility, we kept the position small. 4. In September, our concerns around the potential monetisation of US government debt, in other words the Federal Reserve creating dollars to buy US government bonds, led us to re-introduce some dollar hedges to our global equity allocation. *Note that not all changes apply to all portfolios. For example, currency hedges are not practical in some portfolios, and due to their sustainability profile gold miners were not deemed appropriate for responsible investors.
1JPMorgan Oil Markets Weekly, September 17th 2026.
2 Most major central banks target 2% inflation, although they may use different measures of inflation.
3 “Let The Bond Market Speak”, Stanley Druckenmiller, Wall Street Journal, August 24th 2026.
4In autumn 2022, the Truss UK government proposed aggressive and unfunded tax cuts. UK bond yields jumped over 2.5% in a month, before the Bank of England stepped in to buy bonds, lowering the yields.
5Traditional global currencies are sometimes called “fiat currencies” because their value derives from government decree. Before the current global system, currencies were backed by the gold standard.
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