Democratic victory gives markets reason to rethink interest rate moves

The Democrats’ resounding victory in the US midterm elections could potentially put the brakes on rising global interest rates next year, market watchers say – but uncertain developments in oil prices, US economic growth and fiscal policies will be key.

Central banks around the world are back in monetary tightening mode, with the Federal Reserve, Bank of England, European Central Bank and Bank of Japan all raising rates in recent months.

This change is partly due to the war waged by the United States and Israel against Iran, which has driven up prices in oil and gas markets. The war also exacerbated the reduction in global refining capacity, which caused the cost of products like diesel, gasoline and jet fuel to skyrocket.

Traders widely expected big Democratic gains this week after polls tilted in their favor, but there was still uncertainty ahead of the vote over whether the party would capture both houses of Congress, increasing lawmakers’ ability to challenge President Donald Trump’s policies.

Crude oil prices fell following the Democrats’ clear victory in the House and Senate, with an international benchmark. ICE Brent crude down 8.7% on Wednesday, closing below $100 a barrel for the first time since September.

This has been largely attributed to growing expectations that the outcome could mean Trump is more likely to strike a deal to end the war in Iran, helping to restore Gulf refining capacity and improve export conditions. Vice President JD Vance’s lengthy statement blaming Republican losses on the war in Iran reinforced this view.

Dan Coatsworth, head of markets at AJ Bell, said “the Republican camp admitted that the war in Iran had cost them an election victory, which the market took to indicate that a quick resolution to the Middle East conflict could help them save face.”

“Trump could take advantage of the opportunity to take all the credit if the end of the war leads to a sharp decline in energy costs.”

If the election result “pushes for a resolution to the Middle East conflict, that could cause oil to fall, and that’s been a problem for the Fed and inflation, and that’s part of the reason rates are higher,” said Andrew Slimmon, senior portfolio manager and head of the Applied Equity Advisors department at Morgan Stanley.

Historical data shows a close correlation between oil prices and global rates, Ralph Axel, rates strategist at Bank of America, said in a research note released Thursday. A rise in oil prices over the next three to six months would likely lead to “significantly higher interest rates” in the United States, but particularly in the United Kingdom and Germany, he said.

“If oil prices rise, we believe rates will rise as well, particularly in the short term, where the long-term premium is less of a factor and monetary policy expectations play a larger role,” he added.

As the rise in crude prices on Thursday and the instability on Friday showed, the resolution of the conflict which has lasted for almost nine months is far from guaranteed.

“So far, oil has started to rally again and interest rate expectations have not changed dramatically from pre-election levels,” noted Dan Coatsworth of AJ Bell.

Money markets on Thursday indicated a moderate change in expectations from a week ago in both the United States and Europe, with traders pricing in a slightly higher likelihood of monetary easing a year out.

The effect over a two-year period was more pronounced in the eurozone than in the United States, according to CNBC analysis of LSEG data, with interest rates falling 8.7 basis points over the week for the ECB compared to 4.6 basis points for the Fed.

“Republicans don’t really have a way out at this point,” said Laurel Rapp, U.S. and North America program director at Chatham House. “We know Democrats will seek votes in the House and Senate to constrain Republicans and restrict the administration’s war powers against Iran. But whether that will bind the administration is another matter.”

Eurasia Group’s Clayton Allen, meanwhile, told CNBC’s “Squawk Box Asia” that while war with Iran is unpopular at home, leaving the Middle East region without tangible victories would also be unpopular and that he expects an escalation within weeks.

Andrew Bailey, governor of the Bank of England – which raised rates by 25 basis points on Thursday – told CNBC that pressures on energy prices came from a combination of obstructions on the Strait of Hormuz, a lack of refining capacity and low gas storage in Europe.

“A Middle East peace process is not going to change all of these things,” he told CNBC’s Steve Sedgwick on Thursday.

“Let’s wait and see, because we’ve seen this drop in energy prices over the last 48 hours, but it’s a very volatile situation, as we’ve learned over the last seven, eight, nine months.”

Ken Egan, head of European sovereign credit at KBRA, said the interest rate outlook would be primarily influenced by whether economies have sufficient underlying momentum for existing inflationary pressures to become more persistent.

Europe is “heading into winter after months of high energy prices, and the full impact is still being felt on the economy as a whole,” he said by email.

“The concern for central banks is whether these pressures will start to push up wages and prices more generally, or whether weaker demand will limit this pass-through.”

A key question for the Federal Reserve will be whether the blue sweep “could lead to more fiscal prudence in the United States and thus lower inflation,” Jane Foley, head of foreign exchange strategy at Rabobank, said by email.

“It is very early, however, to be confident about the fiscal outlook, particularly because many Democrats were elected to ease cost-of-living pressures…so it is very difficult to reach a firm conclusion at this point about how the rate outlook will change next year,” she said.

The high level of fiscal stimulus in the United States and whether it is about to change is currently the “million-dollar question,” James Sullivan, managing director and head of Asia-Pacific equity research at JP Morgan, told CNBC’s “Squawk Box Asia.”

“The reasons why inflation is high are a combination of a whole range of factors, from the war in Iran to tariffs to significant tensions in some areas of the energy complex,” he said.

“But it’s also important to recognize that the U.S. government has continued to spend at very high levels, amid an economic expansion accompanied by low unemployment, which carries very specific macroeconomic implications. If that changes, you will potentially ease pressure on the rate environment in a way that will give the Fed significantly greater flexibility.”

Daniel Clifton, head of policy research at Baird Strategas, said the impact on data center construction in the United States was another important factor to watch.

“In 2025, we had major fiscal challenges, and it really doesn’t matter because we had a really big boom in investment in AI development last year. This year was largely driven by stimulus,” he told CNBC’s “Squawk Box Europe.”

“If you have an environment where you have tighter fiscal policy — the Fed is raising rates right now — and you have a slowdown in building AI investments, you’re probably going to make a policy mistake at some point in the middle of 2027,” he said.

“That’s what happened in 2000 during the tech boom of 2000: the Fed was raising rates, we had higher oil prices, and they went too far, and eventually there was a recession. We’re not forecasting a recession in the United States. We’re forecasting a mid-cycle slowdown in 2027.”