Macroscope: The great transatlantic divergence

AI and the Iran conflict are pushing Europe and the US onto sharply different economic and monetary paths.

The old transatlantic playbook is breaking down. For much of the past five years, the US Federal Reserve, the European Central Bank (ECB) 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. Two shocks have now broken that synchrony: the AI investment boom and the Iran war. The US and Europe are now on different trajectories, with meaningful implications for bonds and currencies.

Sahil Mahtani, Director, Investment Institute: "Five years of transatlantic monetary synchronisation are coming to an end. The AI investment boom is keeping the US economy running hotter for longer, while the Iran conflict has tightened financial conditions across Europe before central banks have even acted."

Europe
At the outbreak of the Iran conflict, UK two-year gilt yields surged by more than 70 basis points. Rate expectations flipped from pricing two further cuts to over three hikes at their peak, while in the US, markets were still anticipating cuts. The eurozone saw a similar repricing as markets scrambled to price in the inflation impact of the Strait of Hormuz closure. Overnight, the backdrop changed: higher prices, higher yields and tighter borrowing conditions. All of it happened without a single central bank having acted.

That market-led tightening is already feeding through to European economies. The ECB’s April 2026 bank lending survey, covering Q1 developments and Q2 expectations, 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 put it plainly in a speech in Reykjavík in late May: removing the expectation of future cuts has already materially tightened conditions, and it “is already affecting the economy.” The UK labour market, challenged by a higher minimum wage and the wide-ranging Employment Rights Act 2025, is softening; the housing market continues to lose momentum; and domestic inflationary pressures are easing despite high price levels.

In Sweden, underlying inflation was already subdued. Core inflation ex-energy was running at just 1.1% before the Iran war shock, well below the Riksbank’s own forecasts. Across all three economies, weakening demand is increasingly doing the central banks' job for them. A limited insurance-style policy hike may be needed to anchor inflation expectations and avoid the much-feared second-round effects. But a sustained tightening cycle would risk fighting a battle the market has already begun to win.

Rebecca Phillips, Assistant Portfolio Manager: "Markets have already done much of the ECB's work for it. Higher energy prices, higher yields and tighter borrowing conditions are slowing activity across Europe, creating a more supportive backdrop for European duration than many investors might have expected at the start of the year."

US
The Federal Reserve enjoys no such comfort. Inflation, jobs and economic momentum remain firm. Unlike in Europe, growth is not fading. AI-driven capital expenditure remains a structural demand tailwind, and the latest labour market data points to resilience rather than a slowdown.

In our forecasts, holding current oil prices ($80) and the prevailing core run-rate, US headline CPI stays around 4% well into 2027. Recent inflation prints have continued at the highest levels since early 2023 and reflect not only price pressures coming from energy (which is up nearly 18% year-on-year) but also spillovers of AI-related capex costs into core inflation.

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 looser policy and economic conditions arguing for the opposite.

Markets may eventually be proven right, particularly if the labour market weakens more than headline data currently suggests. But for now, that case remains difficult to make. A Fed chair easing policy into rising inflation would face an immediate credibility test. Markets have a long history of testing new Fed chairs.

What it means for portfolios
While the outcome of the Iran conflict is beginning to take shape, the regional divergence is sharpening between Europe and the US. European duration looks increasingly attractive, supported by the prospect of a soft economic backdrop, underlying disinflation and a market that has already delivered much of the tightening. By contrast, US duration faces continued pressure with above-target inflation and firm domestic demand limiting how far the Fed can cut despite mounting political calls for easing.

Mahtani concluded: "The key story for investors is no longer synchronisation but divergence. Europe and the US are now facing fundamentally different economic realities, and markets have not fully priced the consequences."