Grounds for optimism amid policy divergence

Introduction: Divergent trends

Europe and the UK faced significant headwinds in 2025, including rising trade tensions, ongoing geopolitical concerns, and domestic political uncertainty. Despite these challenges, regional economic growth remained positive, and moderating inflation enabled the European Central Bank and Bank of England to cut rates to three-year lows. However, the pace and timing of these cuts revealed diverging policy paths: the ECB concentrated its cuts in early 2025 as inflation returned to target, while the BoE moved more slowly throughout the year, balancing the need to support a weakening economy against persistently high inflation.  This divergence is expected to continue in 2026, presenting both opportunities and potential volatility for cash investors as policy paths and economic conditions evolve.

EU: Optimism and stability ahead

Looking back on 2025, the ECB can reflect on a job well done, as inflation continued the journey back towards target, while growth proved more resilient than feared in the face of trade uncertainty. This allowed the ECB to dial back monetary policy restrictiveness and return rates to a level closer to neutral.

As we contemplate what lies ahead for 2026, it is worth reflecting on the latest output from the ECB at the December meeting. The most significant developments were the upward revisions to their growth and inflation forecasts. The ECB have become more optimistic that above trend growth is achievable over the forecast horizon. The basis for this being that domestic tailwinds are set to outweigh diminishing external headwinds. Improvements in the Purchasing Manager’s Index (PMI) surveys, since the trade deal with the US in July, support this optimism. Unemployment levels remain near historic lows, real wages remain positive, and savings rates have recently risen, all of which should be supportive for the consumer sector. Fiscal expansion and the lagged effect of monetary easing should also provide a tailwind to growth, supporting business confidence and investment.

On the inflation front, we expect core inflation to remain somewhat stickier next year (revised up from 1.9% to 2.2%) because of higher-than-expected wages. This will act as a counterweight to the small undershoot expected versus target in headline inflation. The ECB has previously stated that small deviations from the target are not a major concern. We also got the first look at 2028 forecasts which has both headline and core inflation back at the 2% target.

The ECB is expected to continue Quantitative Tightening in 2026, further reducing excess reserves within the Euro-system. Although liquidity remains ample for now, the ECB must stay alert for any signs of emerging reserve scarcity, which could lead to higher money market rates. To address such scenarios, the ECB has several tools available, including demand-led Longer-Term Refinancing Operations (LTROs) and, if needed, the introduction of a structural bond portfolio. While these measures may not be required until 2027, they remain important considerations to monitor.

The ECB appears to have concluded its rate-cutting cycle, with President Lagarde describing the euro area as being in a “good place”, with the central banks latest macro forecasts imply that further cuts are off the table, while rate hikes remain premature.  Recent market developments reinforce our view that interest rates are appropriately positioned, with no changes expected in the coming months and a prolonged period of policy stability likely.  Markets are also anticipating EUR rates will remain steady throughout 2026, reflecting confidence in the ECB’s current policy stance and the belief that inflation is under control.   

This stable environment benefits euro-based investors, though attention should remain on political risks in Europe for 2026, particularly France’s efforts toward fiscal consolidation, which, if unsuccessful, could trigger new elections, and Germany’s upcoming state elections, which will test support for the government’s fiscal strategy and could impact the anticipated economic boost.

UK: Diverging policy paths

In contrast, the BoE is still easing, and we expect the BoE to be increasingly in less of a good place as the year progresses, driven largely by persistent consumer weakness and ongoing economic challenges. The UK economy struggled through 2025, with growth stagnating, household consumption softening, and the labour market showing clear signs of deterioration. Unemployment has edged higher, and wage growth is slowing, especially in higher-paying sectors. Inflation has decelerated in line with forecasts but remains above the BoE’s target, adding to the complexity of the policy outlook. The December BoE meeting delivered a fully priced 25bp cut to 3.75%, with a narrow 5-4 vote split highlighting ongoing divisions within the Monetary Policy Committee (MPC).

Looking forward, the Bank of England’s guidance suggests that interest rates will continue to move lower, but at a measured pace. The December statement from the MPC highlighted growing debate within the group, noting that “judgements around further policy easing will become a closer call”. Key factors influencing future decisions will include wage inflation and labour market trends, particularly as significant pay agreements are set to take effect in January and April. As a result, the timing and extent of additional rate cuts remain uncertain, with current expectations for the terminal Bank Rate ranging between 3% and 3.5%. The next cut is expected in April or June 2026, rather than March, and the Committee is in no rush to accelerate the pace of easing. After the latest meeting, it will likely take a material shift in economic data or outlook for the BoE to signal a more aggressive rate-cutting stance.

We believe UK investors should remain attentive to uncertainty, confidence and fiscal risks in 2026. Broader political uncertainty could further weigh on sentiment and inject volatility into sterling and UK rates, making the outlook more challenging for investors. Public sector borrowing has exceeded expectations, adding pressure to inflation-linked expenditures and raising questions about fiscal sustainability.

Conclusion

As we enter 2026, global liquidity investors are navigating a landscape shaped by policy divergence, resilient credit markets, and sustainably higher cash yields. The ECB’s stable outlook and the BoE’s ongoing rate adjustments present distinct opportunities for active management and strategic portfolio positioning. With recession risks remaining low and financial institutions demonstrating robust fundamentals, our disciplined approach to credit selection and duration management is designed to deliver attractive income, flexibility, and capital preservation.

The transition from negative and zero rates to a post-COVID environment of higher cash yields marks a significant shift, empowering investors to benefit from higher interest rates and upward sloping yield curves. Money markets continue to show resilience in spreads and liquidity, making them an appealing choice for those seeking security and returns. In this context, our GBP strategies maintain a moderately long duration position, as we believe the balance of risks points to more rate cuts than the market currently anticipates. We remain focused on delivering attractive income and capital preservation, whilst actively monitoring macro and policy developments to adjust positioning as needed. In this new era, we are committed to helping clients navigate change, seize opportunities, and achieve their investment goals with confidence and clarity.