Fiscal Dominance: Balancing Bond Uncertainty

National economies continue to face historically high debt to GDP ratios – a persistence that drives fiscal dominance, whereby fiscal policy constraints monetary policy, undermining price stability in favour of financing the public debt. As part of our Outlook 2026 webinar, John Briggs – Head of US Rates Strategy, Théophile Legrand – European Rates Strategist, Kohei Iwahara – Economist for Japan and Australia, and Bernard Dahdah – Metals and Mining Expert, discussed their forecasts and how the relationship between fiscal and monetary policy will evolve through 2026.

High debt now characterises most advanced economies; however, the resulting antagonism between fiscal and monetary policy is most acute in the US. The Trump administration’s challenge to the independence of the Federal Reserve (Fed) is weakening confidence in US government bonds.

The president has taken a heavy-handed approach to influencing rate-setting policy by attempting to remove Fed members opposed to speeding up rate cutting. Notably, his attempt to remove Fed Governor Lisa Cook was barred by a district court. In January, the US Supreme Court will consider an appeal to overturn the order. Given the broader implications for central-bank independence, this decision poses the largest threat to US bond markets since Liberation Day back in April, which triggered sell-offs in US government bonds.

Natixis CIB maintains a base case of the Fed easing into higher inflation, expecting 10-year treasuries to reach 4.6% by the close of 2026, pushed up by incoming supply and the need for greater term premiums. A serious threat to Fed independence – a fringe scenario in current models – could see the same bond yields climb to 5%, requiring more drastic strategies. Affordability will be a key issue going into the 2026 midterm, meaning the administration would likely challenge an attempt to control yields by re-introducing quantitative easing.

Separately, concerns over the government’s credit rating and global standing may accelerate dedollarisation. In the near term, a potential second government shutdown and high supply levels risk driving higher yields.

Following the global trend, the Eurozone’s own debt to GDP ratio is projected to remain high into 2026. As the bloc wrestles with fiscal consolidation and increases defence spending, the historically high gross supply is expected to push term premiums and bond yields higher, reinforcing fiscal-dominance pressures.

The record supply – around €1450bn – will not spread evenly across markets. Germany’s fiscal expansion to fund its defence spending bill will contribute around €360bn of supply, making it the most dynamic topic of next year. This is expected to push the German 10-year Bund up by 30bp over 2026 to 3.10%.

Closer to home, the future of French government bonds remains less certain – a presidential election and accompanying budget both present sources of volatility for the 10-year OAT, targeting a spread of 80bp by the end of next year. Uncertainty remains largely political; however, the risk of widening remains low, with fragmentation under control and sovereign spread levels tight. Both mean there is a high bar for intervention by the European Central Bank (ECB), which is likely to maintain its status quo into next year as inflation nears the 2% target.

Incoming pension reform to the Dutch pensions will weaken demand as the retirement income system transitions from benefit to contribution funding. On the long end, the change will disrupt demand as pension funds reduce holdings of government bonds, starting with German Bund and US Treasury bonds. The changes to structural demand are likely to cause steepening on the 10-30 swap curve and the cash curve.

Overall, Europe enters 2026 with high issuance needs but limited monetary-policy flexibility, a classic environment for fiscal-dominance concerns.

Japan faces one of the highest debt-to-GDP ratios among developed nations, currently standing at close to 245%. The newly elected Prime Minister Takaichi’s ¥21trn economic package will push the ratio higher, already triggering a yield rise to 1.8%. This has introduced new uncertainty to markets; however, the low starting yield level makes the rise manageable. In fact, given that yields sat at negative levels, Iwahara at Natixis CIB thinks the historically low levels were unsustainable. As nominal GDP is predicted to grow by 4% and higher tax revenues are set to improve the primary balance, Japan’s fiscal position should stabilise modestly.

Behind the scenes, a tug of war continues between the government and the Bank of Japan (BoJ). Expanding fiscal policy will be moderated by a rate hike, limiting the investment potential of the spending package domestically. A higher rate may generate benefits in the long run; the government and BoJ both agree on the need to increase the base rate to fortify the Yen’s struggling recovery, making tightening the likely course of action for delivering Yen appreciation in 2026.

Japan’s large stimulus and rising rates reflect a clear fiscal-dominance tension as policymakers balance growth goals with currency stabilisation.

In the coming year, geopolitical and trade uncertainty will continue to dampen global growth. Across developed economies fiscal dominance through government spending will interact with monetary policy as central banks attempt to control inflation.

The independence of the US Fed will have the largest impact on global markets as a loss of confidence could spur further sell-offs in US Treasury bonds and accelerate dedollarisation. The EU’s push for greater autonomy will require further fiscal expansion but confidence grows in the ECB’s transmission of monetary policy reaching the 2% inflation target.

Political dissatisfaction remains a source of risk but is unlikely to impact the policy trajectories. In Japan, the new Prime Minister’s focus on business competitiveness shows promise for economic recovery and appreciation in the Yen’s value. Overall, 2026 will test how far advanced economies can stretch fiscal policy without compromising monetary independence – a defining theme for global bond markets.