The old transatlantic playbook is breaking down. For much of the past five years, the Federal Reserve, European Central Bank and Bank of England have broadly moved in the same direction: first tightening aggressively to contain inflation, then preparing to ease as price pressures cooled.
That synchronisation is now coming to an end. Two shocks have altered the outlook: the AI investment boom and the war in Iran. The US and Europe are now on different trajectories, with meaningful implications for bonds and currencies.
In the US, AI-related capital expenditure is keeping the economy running hotter for longer. In Europe, the Iran conflict has tightened financial conditions before central banks have even acted. For investors, the key story is no longer synchronisation, but divergence.
At the outbreak of the Iran conflict, two-year gilt yields surged by more than 70 basis points. UK rate expectations shifted sharply, from pricing two further cuts to more than three hikes at their peak. In the US, by contrast, markets were still anticipating cuts. The eurozone saw a similar repricing as investors moved quickly to reflect the inflationary impact of the Strait of Hormuz closure.
Almost overnight, the European backdrop changed: higher energy prices, higher yields and tighter borrowing conditions. Crucially, this tightening happened without a single central bank having raised rates.
That market-led tightening is already feeding through to the real economy. The ECB’s Q2 2026 bank lending survey showed credit standards tightening at their fastest pace since Q3 2023. Banks are becoming more cautious about lending and less supportive of growth.
In the UK, Governor Bailey made the point clearly in a speech in Reykjavík in late May: removing the expectation of future rate cuts has materially tightened financial conditions and is already affecting the economy. The labour market, already challenged by a higher minimum wage and the Employment Rights Act 2025, is softening. The housing market continues to lose momentum, while domestic inflationary pressures are easing despite high price levels.
In Sweden, inflation was already subdued before the shock arrived. Core inflation excluding energy was running at just 1.1%, well below the Riksbank’s own forecasts.
Across Europe, weakening demand is increasingly doing central banks’ work for them. One insurance hike may still be needed to anchor inflation expectations and guard against second-round effects. But a sustained tightening cycle would risk fighting a battle the market has already largely won.
This creates a more supportive backdrop for European duration than many investors might have expected at the start of the year. Higher energy prices, higher yields and tighter borrowing conditions are slowing activity across the region, while underlying disinflation remains intact.
The Federal Reserve enjoys no such comfort. Inflation, employment and economic momentum remain firm. Unlike in Europe, growth is not fading. AI-driven capital expenditure is providing a structural demand tailwind, while the latest labour market data points to re-tightening rather than slowdown.
In our forecasts, assuming current oil prices and the prevailing core inflation run-rate, US headline CPI remains above 4% well into 2027. April’s 3.8% print was the highest since May 2023. It reflected not only energy price pressures, with energy up nearly 18% year-on-year, but also spillovers into core inflation from AI-related capital expenditure.
Markets have interpreted the appointment of Fed Chair Kevin Warsh as broadly dovish, with rate cuts expected once the data allows. But elevated inflation, resilient demand and higher oil prices may leave him with less room to ease than investors expect. The Fed could soon find itself caught between political pressure for lower rates and economic conditions arguing for the opposite.
Markets may yet be proved right, particularly if the labour market weakens more than the headline data currently suggests. For now, however, that case is difficult to make. A Fed chair easing policy into rising inflation would face an immediate credibility test and markets have a long history of testing new Fed chairs.
While the outcome of the Iran conflict remains uncertain, the regional divergence between Europe and the US is becoming sharper.
European duration looks increasingly attractive. It is supported by the prospect of a single ECB insurance hike, underlying disinflation and a market that has already delivered much of the tightening.
US duration faces a more challenging backdrop. Inflation remains elevated, demand is resilient and the Federal Reserve has limited room to ease, despite political pressure for lower rates.
For investors, the implications are clear: Europe and the US are now facing fundamentally different economic realities, and markets have not yet fully priced the consequences.
