Bondford Report : 2026 Q1 - Economic & FX Outlook

USD - At a Crossroads

USD Index Bearing Down

Source: Bloomberg

The US dollar ended 2025 struggling for clear direction, reflecting the broader difficulty investors have had in interpreting the state of the US economy. Data blackouts, revisions, and seeming contradictions have left markets without their usual compass. What little reliable information remains point to an economy at an inflection point, with a deteriorating labour market even as inflation remains stubbornly elevated.

This uncomfortable combination has reopened tensions at the heart of the Federal Reserve’s dual mandate. At the same time, erratic policymaking from Washington has amplified uncertainty for businesses, households, and public officials alike, stalling decision-making across large parts of the economy and weighing heavily on sentiment.

A K-Shaped Economy and the AI Mirage

Adding to the complexity is the increasingly uneven nature of US growth. One narrow but influential segment of the economy, technology, is booming, fuelled by extraordinary levels of investment in artificial intelligence. Equity markets have surged as a result, reinforcing the perception of US exceptionalism.

Yet this prosperity is far from broad-based. Consumer confidence has slumped amid what some describe as a “K-shaped” economy. Asset-rich households are benefiting from rising equity prices, while cash-constrained consumers face an affordability crisis and weakening job security.

Volatile NFP Data Muddies the Outlook

Source: U.S. Bureau of Labor Statistics

There are also growing doubts over the sustainability of the AI-driven rally. Valuations look increasingly speculative, with legitimate questions surrounding both the productivity gains and revenue potential of AI applications. Should this bubble burst in 2026, the repercussions for equity markets - and by extension the dollar - could be severe. It is no coincidence that investors increasingly seek protection in alternative assets such as precious metals and bitcoin, as well as in currencies like the euro and yen.

The Fed: Divided, Cautious, and Politicised

The dollar’s upside is also constrained by expectations that the Fed will continue along the policy-easing path it resumed in September. As labour market deterioration starts to take precedence over inflation, the prospect of further rate cuts has weighed on the dollar by eroding its yield advantage.

That said, the pace and extent of easing remain far from clear. The Fed has become increasingly divided, with recent meetings producing unusually fragmented voting patterns, including three-way splits, highlighting the lack of consensus on the appropriate response.

The balance of power at the Fed could yet shift. President Trump will soon announce his nominee to replace Powell when his term ends in May 2026, with markets anticipating a more politically-aligned candidate favouring aggressive rate cuts. However, the institution’s independence may yet prove more resilient than feared. Recent votes suggest that individual committee members are willing to prioritise their own judgements over peer or political pressure, potentially limiting any dramatic shift. Ironically, it is this uncertainty over policy that has prevented the dollar from weakening more decisively.

Flying Blind: The Data Problem

Compounding matters is an unusually high degree of economic uncertainty. The government shutdown from October 1 to November 12 - the longest on record - disrupted data collection across multiple agencies, leaving gaps that may never be fully repaired. Businesses and policymakers alike have been forced to operate without reliable guides.

Missing and Incomplete Data Complicates Inflation Judgements

Source: U.S. Bureau of Labor Statistics

October’s CPI release has been permanently lost from the historical series, while November’s abrupt undershoot to 2.7% was based on only partial data collection, raising serious questions about its reliability. Even the flagship Non-Farm Payrolls report has been called into question following unusually large revisions.

In this environment, it is unsurprising that policymakers have erred on the side of caution. Among the remaining indicators, unemployment appears to be the most dependable signal. Its rise to a four-year high of 4.6% in November has become a key reference point for both markets and the Fed.

Politics, Tariffs, and the Erosion of Trust

The political backdrop has done little to stabilise expectations. Tariffs have dominated headlines throughout 2025, but their implementation has been erratic - marked by abrupt announcements and reversals.

With US midterm elections approaching in November, policymaking risks becoming even more volatile. Weak polling for Republicans raises the prospect of losing the House, while ongoing legal challenges to key administration policies could provoke further confrontational responses from the White House. For currency markets, this political noise translates directly into higher risk premia.

Bondford’s Outlook – USD

According to the latest Bloomberg consensus, the US dollar is expected to lose ground against both the euro and the pound over the next 12 months. This reflects expectations of a slow erosion of US rate differentials and stabilising growth in Europe.

Three broad scenarios stand out:

• Managed Softening:
  The most likely outcome is a controlled dollar decline as the Fed cautiously eases policy and growth slows without tipping into recession.

• Disorderly Downturn:
  A sharper deterioration in labour markets, a correction in equity valuations, or policy missteps amid poor data visibility could lead to a more abrupt dollar sell-off.

• Resilient Exception:
  A less probable but still plausible outcome is renewed dollar strength if US growth proves resilient and global risk aversion rises, reviving safe-haven demand.

“The dollar still benefits from America’s innovation and market depth - but in an economy flying blind, with politics clouding policy, its era of effortless dominance looks increasingly fragile.”

EUR - Strength with Strings Attached

Euro Maintains Four-Year Highs

Source: Bloomberg

The Euro continues to trade near four-year highs against the dollar, underpinned primarily by divergent monetary policy expectations among the major central banks. While the Fed and Bank of England are increasingly focused on how far and how fast interest rates can fall in response to weakening labour markets, the ECB remains comparatively relaxed. The question is whether this policy asymmetry can sustain the Euro’s strength into 2026, or whether growing political and external risks will limit further gains.

ECB Confidence, but Not Without Friction

ECB President Christine Lagarde has repeatedly emphasised that the euro area is “in a good place”, with little pressing need to adjust policy. The carefully neutral messaging is deliberate: it projects calm, reinforces control, yet preserves flexibility. A central bank that is not preparing the ground for imminent easing stands out in an environment where others are.

Recent data support this cautious confidence. Economic growth, while far from impressive, has consistently exceeded expectations. Inflation, meanwhile, is hovering just above the 2% target. In contrast to the US and UK, discussion is framed around whether the next policy move will ultimately be up or down, rather than on the timing of rate cuts amid sticky inflation.

Inflation Hovering Near Target

Source: Eurostat

That said, the ECB’s apparent comfort masks internal tensions. Services inflation remains elevated, leaving some policymakers alert to the risk of renewed price pressures in 2026. At the same time, aggregate growth figures conceal wide divergences across member states, with Germany and Italy flatlining at the end of 2025. The broader issue remains: euro area growth is increasingly reliant on domestic demand as the external environment becomes more hostile.

External Pressures Mount as Trade Risks Re-emerge

External risks are becoming harder to ignore. Europe finds itself increasingly squeezed between its two most powerful trading partners, the US and China, and has come off worse against both over the past year. The settling of US tariffs at 15% has provided some needed clarity, but at a cost to Europe’s exporters. Yet, tensions have not ended there. President Trump’s just released National Security Strategy singled out Europe for sharp criticism, portraying the bloc as an unreliable partner, hamstrung by regulation and a loss of identity as it slides into irrelevance. See more on this here:

While some of the document’s rhetoric may never translate into concrete policy, given the political constraints Trump faces ahead of challenging midterms, the direction of travel is unmistakable. Europe will need to become more self-reliant and adapt to shifting power dynamics in an evolving global order.

Relations with China have deteriorated in parallel. In retaliation for EU measures on cheap Chinese EV imports, Beijing announced levies of 42.7% on EU dairy products. Europe’s response has been hesitant: the “Made in Europe” initiative has stalled amid internal disagreement and slow execution, while the long-awaited Mercosur trade deal, 25 years in the making, is threatened by domestic opposition at the final hurdle.

These challenges reinforce a persistent narrative of a bloc that struggles to act decisively or speak with a unified strategic voice. This, more than monetary policy, may explain why the Euro has not performed even better against the dollar or sterling, despite a favourable policy backdrop.

Political Risk: France the Key Fault Line

Domestic politics add another layer of risk. In France, the government narrowly avoided collapse after failing to pass a budget for 2026, forcing it to roll over the previous year’s framework. This limits the scope for investment or meaningful fiscal consolidation, and attempts to force legislation through parliament risk triggering a no-confidence vote and early elections - an outcome that would unsettle European financial markets.

There are, however, some stabilising factors. Germany’s coalition government has survived a rebellion over pension reform and remains intact for now. In an increasingly fragmented global environment, political stability at the heart of European policymaking would be a meaningful asset that could enhance the Euro’s appeal as an alternative to an increasingly volatile and inward-looking United States.

Rate Differentials Converging In the Euro’s Favour

Source: Haver Analytics

Bondford's Outlook - Euro

The near-term outlook for the Euro can be framed around two plausible scenarios:

• Baseline scenario:
  With the ECB under little immediate pressure to ease policy, interest rate differentials remain supportive. Provided political risks in France are contained and trade tensions do not escalate, the Euro should consolidate recent gains. This aligns with the latest Bloomberg consensus forecasts, which point to modest appreciation over the next 12 months, with EUR/USD heading towards $1.19, and GBP/EUR to €1.13.

• External or domestic risks crystallise:
  A renewed escalation in transatlantic trade tensions or a deterioration in domestic political cohesion would undermine confidence and reintroduce a risk premium into Euro assets. Concerns around growth and fiscal sustainability would come back to the forefront, leaving the currency vulnerable to bouts of fresh underperformance.

For now, markets appear to be leaning towards the former outcome. Whether that optimism is sustained depends as much on decisions in Frankfurt as on Europe’s ability to navigate an increasingly fractious global landscape without adding to its own internal strains.

“The Euro is supported by policy stability, but its upside will ultimately be determined by Europe’s ability to manage politics and trade, not monetary policy alone.”

GBP - Fiscal Relief, Monetary Tension

GBP vs. US Dollar in 2025

Source: Bloomberg

After coming under pressure for much of the last quarter, the pound rebounded in the final month of 2025 as the November Budget eased concerns over the sustainability of the UK’s public finances. In the lead-up, markets had grown increasingly uneasy about the government’s ability to deliver credible fiscal decisions, with internal rebellions against spending restraint undermining confidence, pushing up gilt yields, and driving sterling volatility. An unprecedented volume of policy leaks and contradictory briefings ahead of the Budget further amplified these tensions.

Whether by design or by accident, expectations were set extremely low. Against that backdrop, the Budget itself came as a relative relief. Its centrepiece was the creation of a £21.7bn fiscal buffer, more than double the previous level of headroom, which materially reduced the risk of repeated, piecemeal tax rises at future fiscal events. Sterling rallied as investors concluded that the near-term fiscal risk premium embedded in UK assets had eased.

10-Year Gilt Yields Stabilise Lower Post-Budget

Source: Investing.com

That said, there was little in the Budget to actively cheer. A smorgasbord of tax increases and higher welfare spending appeared aimed more at placating restless backbench Labour MPs than lifting long-term growth. Consequently, the absence of significant new cost burdens for businesses was taken as a quiet positive.

Ultimately, the Budget achieved its core objective: buying the government time. In doing so, it helped stabilise gilt markets and removed an immediate source of downward pressure on the pound.

Monetary Policy Back in the Spotlight

With fiscal risks temporarily contained, monetary policy will be the primary driver of sterling in early 2026. Here, the picture is finely balanced.

Recent data increasingly support the case for further rate cuts. UK GDP is effectively flatlining, unemployment has risen to a four-year high of 5.1%, and inflation has fallen sharply - from a peak of 3.8% over the summer to 3.2% in November. These inflation outcomes have undershot the Bank of England’s earlier projections, and there now appears a path toward reaching the 2% target by April 2026, helped in part by Budget measures on energy and transport costs that will knock an estimated 0.5 percentage points off CPI.

Concerning Rise in Unemployment

Source: Trading Economics

However, the MPC remains starkly divided between hawks and doves, with Governor Bailey ultimately casting the deciding vote at recent meetings. The more hawkish members point to elevated wage growth and stubbornly high inflation expectations, factors that could complicate the “last mile” of disinflation.

Inflation Falling Rapidly From Q3 Peak

Source: Trading Economics

Markets had previously priced in two further rate cuts during 2026, but the persistence of this hawkish bloc raises questions about how far and fast rates can fall. Governor Bailey has reiterated his expectation of a “gradual downward path” for rates, while warning that decisions may become harder as policy approaches a neutral, or “terminal”, rate. Where this ultimately settles will be crucial for sterling.

The pound is therefore likely to remain sensitive to incoming data and relative monetary policy developments abroad. At present, the Bank of England sits in an awkward middle ground: more hawkish than the Fed, but more dovish than the ECB.

Politics: Fewer Domestic Risks, More External Ones

Politics will also remain a factor in sterling dynamics. Domestically, the outlook appears comparatively stable. With the next general election not due until 2029 and Labour holding a majority of more than 150 seats, the risk of near-term political upheaval is low.

The greater risks may lie abroad. Relations with the EU remain strained, with disputes over youth mobility and access to defence funding highlighting the UK’s limited leverage in negotiations. Meanwhile, ties with the US have also come under pressure, after talks on a Technology Prosperity Deal stalled amid accusations of unfair treatment of American tech firms.

In a stronger economic environment, the UK might be better placed to absorb these external shocks. Instead, with growth expected to remain well below 2% for the foreseeable future, sterling remains exposed to developments beyond the government’s direct control.

Bondford’s Outlook – GBP

According to the latest Bloomberg consensus forecasts, the pound is expected to appreciate gradually against the US dollar, rising to around $1.36 by the end of 2026. Against the euro, by contrast, sterling is projected to weaken modestly, to around €1.13 over the same period.

These forecasts reflect a view that fiscal risks have stabilised and that monetary easing will proceed cautiously. However, the balance of risks around this baseline remains wide. Two broad scenarios stand out:

• Range-Bound Base Case:
  Weak growth is offset by cautious monetary easing and a steady, if uninspiring, policy backdrop. Sterling trades sideways, with modest gains against the dollar capped by soft domestic data, and mild underperformance against the euro as the ECB maintains a firmer stance.

• Renewed Downside Pressure:
  A less favourable outcome could emerge if growth deteriorates more sharply, or political tensions -domestic or international - reignite credibility concerns. Markets may price more aggressive Bank of England easing, leaving the pound vulnerable, particularly against currencies backed by tighter policy.

“Sterling has bought itself some breathing room, but without stronger growth, the pound’s upside looks limited—and highly dependent on how aggressively the Bank of England chooses to cut.”

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