Markets navigated a hawkish Fed pivot, contrasting global growth dynamics, and shifting rate expectations as central banks entered their final policy meetings of 2025.

The Fed's Reluctant Cut

The Federal Reserve's December meeting delivered the expected 25bp cut but with an unmistakably hawkish tone that caught markets off guard. Three dissenters—spanning both ends of the spectrum—highlighted deep divisions within the committee. More significantly, the dot plot revealed expectations for just one additional cut in 2026, a stark departure from the two cuts markets had priced.

What made this particularly hawkish wasn't what the Fed did, but what their forecasts implied. Growth expectations were lifted 50bp for 2026, unemployment is projected to decline from here, yet core inflation forecasts were barely adjusted. Fed Chair Powell's message was: with the economy strengthening and the labour market resilient, what's the rush to ease further?

The result? A sharp repricing of rate expectations globally. As Sally Auld noted, "it does feel like there is a bit of a shift in market expectations around central bank behaviour"with Australia, Canada, Europe, and potentially the Fed all now seeing markets probe for the next move being up rather than down.

China's Struggle Intensifies

The week's China data painted a troubling picture. Retail sales growth slumped to 1.3% year-on-year—the weakest since 2022—while fixed asset investment tumbled and house prices continued their relentless decline. 

What's particularly concerning is Beijing's apparent lack of urgency. Despite acknowledging domestic weakness since September 2024, policy responses remain inadequate. Short-term consumption incentives have provided temporary relief that quickly fades. The currency has been gradually strengthening, hardly the response you'd expect from authorities genuinely concerned about growth momentum.

Markets have been sanguine, suggesting either complacency or resignation that meaningful stimulus won't arrive until March at the earliest. With the export engine—a key growth driver in 2025—likely to slow in 2026, China faces a soft start to the new year or something worse if the rest of the world slows.

Japan's Surprising Strength

In stark contrast, Japan's Tankan survey exceeded expectations (34 vs 28), with both large and small businesses showing improved sentiment. The Takahashi fiscal support appears to be working, creating genuine optimism across the corporate sector. With inflation running above 3% for 49 consecutive months and fiscal stimulus now feeding through, the Bank of Japan has a clear runway for policy normalisation this week.

Australia's Labour Market Wobble

Friday's employment report provided the RBA with its first piece of genuinely soft data in months. A 56,000 decline in full-time jobs (offset by 35,000 part-time gains) saw bond yields tumble 9bp on the day. While the unemployment rate held at 4.3%, the decline in participation and rise in underemployment suggest underlying softness.

The question is if this a one-month anomaly or the start of a genuine labour market cooling? With another employment report due January 22nd before the February RBA meeting, one data point isn't enough to derail the hawkish tilt. But if sustained, it could push back market pricing for rate hikes that had been building.

Europe's Green Shoots

Industrial production surprised to the upside (+0.8% in October), German and French inflation softened (Germany actually recorded deflation at -0.2%), and broader sentiment continues to improve. With German infrastructure and military spending only now kicking in, the growth outlook for early 2026 appears constructive, a remarkable turnaround from the pessimism earlier in the year.

Market Implications

Equity markets have been treading water recently with notable underperformance from Japan and the Nasdaq. Tech stocks remain under pressure following Oracle's revelation of $50bn in AI spending plans, renewing concerns about return on massive capital deployment.

Gold continues to trade in an elevated range around $2,700/oz, seemingly content to consolidate recent gains. Bond yields, however, have been the standout move. Australian 10-year yields have surged 26bp this month to 4.82%, dramatically outpacing the 9bp rise in US Treasuries to 4.18%. This divergence reflects both the RBA's hawkish lean and the market's reassessment of Australia's inflation risks relative to offshore peers.

The US dollar's 1.6% weekly decline suggests markets are questioning the "American exceptionalism" narrative, though it's too early to call this a sustained reversal.

Looking Ahead

With the ECB and Bank of Japan meetings still to come this week, alongside November payrolls data from the U.S. (finally catching up after the government shutdown), markets face a critical test. The key questions for 2026 include the sustainability of growing divergence between regions—China struggling, Japan strengthening, Europe stabilising, Australia grappling with persistent inflation, the U.S. demonstrating resilience without triggering broader financial stress?

The Fed's hawkish pivot and resulting rate repricing globally suggests 2026 will be a year of central bank policy divergence rather than convergence. For markets accustomed to synchronised easing cycles, that adjustment may prove more challenging than anticipated. In this week’s What We Are Working on video we discuss how to navigate these challenges with Andrew Hunt of Hunt Economics. The key takeaway? Stay alert but not alarmed and it may not be the time to make bold predictions just because the 1st of January looms.