As investors debate whether and when the Federal Reserve will raise interest rates, expectations for further tightening are rising globally, spelling trouble for bond markets. Traders anticipate that borrowing costs in Japan, Canada, the Eurozone, and the UK will increase faster than in the US over the next year. Among 32 interest rate swap markets tracked by media, two-thirds already reflect rate hike expectations, led by South Korea, where pricing suggests increases exceeding 100 basis points. This marks a shift from the rate cycle dominated by the Fed in recent years.
Central banks now face a confluence of pressures: oil price surges from the Iran conflict, substantial government spending increases, and strong growth momentum from the AI investment boom. Inflation in OECD member countries has recently risen to its highest level in two years. This creates an unsettling prospect for investors: bonds, which should traditionally buffer portfolios during downturns—such as a reversal of the AI-driven stock rally or another trade war impacting economic growth—may instead amplify losses if central banks outside the US are forced to tighten policy more aggressively. This could undermine a fundamental diversification principle in traditional asset allocation.
From a diversification perspective, it has stopped working, said George Efstathopoulos, a portfolio manager at Fidelity International, which manages over $1.1 trillion in assets. He holds almost no government bonds, only some US Treasury Inflation-Protected Securities (TIPS) and Brazilian bonds. In a world with more geopolitical events, higher energy dependence, stickier inflation, and massive fiscal stimulus, it is very likely to see inflation become more resilient, he added.
Data shows traders currently expect a combined rate hike of about 400 basis points across seven major markets in the next year. If these expectations prove correct, the impact could extend beyond bonds, potentially dragging down high-valuation stocks, as rising rates reduce the present value of future earnings, tighten financial conditions, and disrupt foreign exchange markets. Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, noted that rising rates also increase the returns from simply holding cash, giving investors more options. In other words, governments and companies must offer higher yields to attract capital.
As energy costs rise, the AI-driven investment boom is boosting demand for chips, electricity, and labor, with Seoul and Tokyo expected to lead the next wave of global tightening. Bonds in both countries are already under pressure. In local currency terms, South Korean government bonds have fallen nearly 9% this year, the worst performance among 44 tracked bond markets. Japanese bonds are also among the biggest losers, down about 4%. In Europe, rising energy costs and surging defense spending are weighing on the economic outlook. France's benchmark 10-year bond yield hit its highest level since 2009 on Friday, while yields on German and Italian 10-year bonds have risen over 30 basis points this year.
However, some investors are more optimistic on European bonds. The European Central Bank was among the first to raise rates after the global energy shock, signaling a more aggressive stance against inflation. Fund managers also see more predictable fiscal and monetary policy prospects in Europe compared to the US or Japan. Iain Stealey, International Fixed Income Investment Chief at JPMorgan Asset Management, said he prefers European bonds over US bonds, especially UK gilts. He expressed confidence in buying the front end of the European yield curve, particularly the UK, and does not believe the Bank of England is in a hurry to raise rates.
In the US, as inflation concerns cool, bond traders are no longer fully pricing in a rate hike this year. Still, the 10-year US Treasury yield has risen about 50 basis points this year, and borrowing costs for the recent 30-year bond auction hit the highest level in decades, reflecting worries about widening fiscal deficits. Kenneth Goh, a wealth management director at UOB Kay Hian in Singapore, noted that bonds now occupy a much smaller position in portfolios compared to a decade ago. With expectations of synchronized tightening across major economies, the protection offered by diversifying bond holdings across markets is less effective than when monetary policy cycles were divergent. He added that many investors still assume bonds will buffer their portfolios, but they are no longer functioning that way.
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