Dagmara Fijalkowski delivers a timely fixed income forecast for Q1-2026, addressing AI debt trends, Fed hesitancy, and easing geopolitical tensions. Dan Mitchell shares insights on the U.S. dollar’s decline and emerging market currency opportunities.
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Transcription
How will inflation, rates, and fiscal policies impact fixed income markets in Q1-2026?
Dagmara Fijalkowski
After September's market rally, the past two months have been defined by caution. Investors have been looking over their shoulders or as proverbially known, climbing a wall of worry. But beneath the volatility lies resilience. Let's break down our outlook for the first quarter of 2026. First, the main concerns. Credit risks hidden in private markets became a forefront of concerns as collapse of First Brands and Tricolor shone spotlight on connections between Business Development Corporations and banks.
Second, tech giants started fueling AI growth with debt. AI CapEx share of investment-grade debt grew to 14.5% of J.P. Morgan investment-grade index. That's more than financials. And third, Fed hesitation. Minutes of October's meeting dimmed hopes for a December rate cut. By late November, VIX spiked to 25%, yet the S&P500 was just 2% of highs - a testament to market grit.
Geopolitically, tensions have eased. US-China relations stabilized after the rare earths debacle. Middle East agreement and the return of hostages reduce the risk in the area. And, even domestic uncertainties like concerns about the Fed's independence, came off the boil for now. GDP growth remains robust. Past rate cuts, tax cuts, deregulation, and fading tariff-driven inflation are tailwinds. We expect further Fed easing as inflation pressures wane, and the markets price 4 cuts in the next 12 months.
We see more nuance in this market pricing. It's not a forecast, but rather, an average of at least two competing paths. First, one with fewer cuts if inflation persists. Or, another one with more aggressive cuts pushing rates below 3% if unemployment goes up. A potential dovish shift under the new dovish Fed Chair could tip the balance towards more cuts if inflation doesn't go up.
Speaking about bonds, let's highlight the resilience! This year, the US10Y has defied bearish calls, averaging 4.3% since election last year. Our base case? Cash-like returns unless growth slows sharply. We favour cash over bonds for now, but we watch for deficit spikes or other nasty fiscal surprises. Finally, a few words about credit markets. They are in mature consolidation phase, the longest stage of the cycle. Capital gains are limited, but coupons remain attractive. Our recommendation is to prioritize high-conviction holdings. For example, in the shorter end of the investment grade universe in Canada and minimize high risk exposure. In short, markets will stay volatile, but growth and policy tailwinds persist. We stay focused on quality, monitor Fed shifts and are prepared to take advantage of opportunities down the road.
Calm and patient is the opening stance for fixed income in 2026.
Will the U.S. dollar continue to decline in 2026?
Daniel Mitchell
It's been another busy year for foreign exchange markets, with some heated debate over the fate of the U.S. dollar. The greenback fell for the first half of 2025, it declined by about 10% on the trade-weighted basis, but then sort of stalled in the summertime as stronger economic growth, some delay of interest rate cuts that were expected, and continued AI spending at the big tech companies sort of kept the dollar supported for a while.
Also, President Trump used his stance on trade tariffs that took some pressure off of the U.S. economy, and this whole issue of Fed independence had sort of been sidelined for now. But those two themes still very much remain in the air. And keep in mind, we’ve got the U.S., Canada, Mexico trade deal coming up for renewal in early 2026, and a new Fed chair that's going to be nominated in January. So, you know, policies coming out of the White House will still very much be a driver for currency markets in the new year, and we wouldn't be surprised if that keeps downward pressure on the currency. Whether it's because the Fed is being influenced or not, it does appear likely that we'll see some continued rate cuts out of the U.S., at the same time as other central banks globally start thinking about interest rate hikes. That makes the U.S. a less attractive investment destination for foreign investors, and also has them questioning whether they should be hedging their large holdings of U.S. assets.
For our part, we're expecting another year of decline for the greenback, and it's likely that this will support all currencies globally. But perhaps the best performers next year will be emerging market currencies, which are themselves being supported by low market volatility and still-supportive risk sentiment. So just to put some context around that, we've penciled in returns about 5 to 8% for the euro, the yen and the Canadian dollar. Whereas we think emerging market currencies can deliver total returns over 10%.