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The Democrats' resounding victory in the U.S. midterms has the potential to curb interest rate hikes globally next year, according to market watchers — but the uncertain path of oil prices, U.S. 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.
The shift has in part stemmed from the U.S. and Israel's war with Iran driving up prices in oil and gas markets. The war has also exacerbated a squeeze in global refining capacity which has sent the cost of products like diesel, gasoline and jet fuel soaring.
Traders largely expected big Democratic gains this week after polls pointed in their favor, but there was still uncertainty leading up to the vote about whether the party would capture both chambers of Congress, increasing the ability for lawmakers to challenge President Donald Trump's policymaking.
Crude oil prices tumbled following the clear-cut Democratic victory in both the House and Senate, with international benchmark ICE Brent crude falling 8.7% on Wednesday, closing below $100 a barrel for the first time since September.
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That was largely attributed to raised expectations that the result may mean Trump is more inclined to strike a deal to end the war in Iran, helping restore Gulf refinery capacity and improve export conditions. Vice President JD Vance's lengthy statement blaming Republican losses on the Iran war boosted that view.
Dan Coatsworth, head of markets at AJ Bell, said there had been "an admission from the Republican camp that the Iran war cost them a clean sweep in the election, which the market has taken to indicate that a swift resolution to the Middle East conflict could help them save face."
"Trump might relish the opportunity to take all the credit if an end to the war leads to a big drop in energy costs."
If the election result "pushes for a resolution of the conflict in the Middle East, that might bring oil down, and that's been an issue for the Fed and inflation, and part of the reason why rates are higher," said Andrew Slimmon, senior portfolio manager and head of the Applied Equity Advisors at Morgan Stanley.
Historic data shows a tight correlation between oil prices and global rates, Ralph Axel, rates strategist at Bank of America, said in a research note published Thursday. Higher oil prices over the next three to six months would likely mean "significantly higher interest rates" in the U.S., but especially so in the U.K. and Germany, he said.
"If oil prices rise, we think rates will too, especially at the front end where long-end term premium is less of a factor and monetary policy expectations play a larger role," he added.
No off-ramp for Republicans
As the uptick in crude prices on Thursday and choppiness on Friday showed, a resolution to the nearly nine-month-long conflict is far from locked in.
"For now, oil has begun to climb back up again, and interest rate expectations have not radically changed from pre-election levels," AJ Bell's Dan Coatsworth noted.
Money markets on Thursday indicated a moderate change in expectations from a week ago, both in the U.S. and Europe, with traders pricing in a slightly higher chance of monetary easing on a one-year horizon.
The effect on a two-year timeframe was more pronounced in the euro area than the U.S., according to CNBC analysis of LSEG data, with rate pricing down 8.7 basis points on the week for the ECB versus 4.6 basis points for the Fed.
"Republicans don't really have an off-ramp here at this stage," said Laurel Rapp, director for the U.S. and North America Program at Chatham House. "We know the Democrats will seek to take votes in the House and the Senate to constrain the Republicans, to restrain the administration on Iran war powers. But whether that will bind the administration is another matter."
Eurasia Group's Clayton Allen meanwhile told CNBC's "Squawk Box Asia" that while the war with Iran is unpopular at home, leaving the Middle East region without tangible wins would also be unpopular and that he expected an escalation within weeks.
Andrew Bailey, governor of the Bank of England — which hiked rates by 25 basis points on Thursday — told CNBC that energy price pressures stemmed from a combination of obstructions on the Strait of Hormuz, a shortage in refining capacity, and low European gas storage.
"A peace process in the Middle East will not shift all of those elements," he told CNBC's Steve Sedgwick on Thursday.
"Let's wait and see, because we have seen that fall in energy prices over the last 48 hours, but it is a very volatile situation, as we've learnt over the last seven, eight, nine months."
Ken Egan, head of European Sovereign Credit at KBRA, said the interest rate outlook would be primarily impacted by whether economies have enough underlying momentum for existing inflation pressures to become more persistent.
Europe is "heading into winter after months of elevated energy prices, and the full impact is still feeding through to the wider economy," he said by email.
"The concern for central banks is whether these pressures start to push up wages and prices more broadly, or whether weaker demand limits that pass-through."
Growth outlook
A key question for the Federal Reserve will be whether the blue sweep "could lead to more fiscal prudence in the U.S. and thus less inflation," Jane Foley, head of FX strategy at Rabobank, said by email.
"It is very early, however, to be sure of the fiscal outlook, not least because many Democrats were voted in to soften cost of living pressures ... so it is very difficult to come to a firm conclusion at this point as to how the outlook for rates will change next year," she said.
The high level of U.S. fiscal stimulus and whether it is about to change is the "million dollar question" right now, James Sullivan, managing director and head of Asia Pacific equity research at J.P. Morgan, told CNBC's "Squawk Box Asia."
"The reasons why you're seeing inflation running high is a combination of a range of factors, from the war in Iran, to tariffs, to significant tightness in particular areas of the energy complex," he said.
"But it's also important to recognize the U.S. government has continued to spend at very high levels, into an economic expansion with low unemployment, and that's driving very specific macroeconomic implications. If that changes, you potentially take the pressure off the rate environment in a way that gives the Fed significantly more forward flexibility."
Daniel Clifton, head of policy research at Baird Strategas, said the impact on the data center buildout in the U.S. was another big factor to watch.
"In 2025, we had major fiscal headwinds, and it really didn't matter because we had such a big capex boom in the AI build-out last year. This year was driven a lot 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 the AI capex build out, you're probably going to reach a policy mistake at some point in mid-2027," he said.
"That's what happened in 2000 during the Y2K tech boom, the Fed was raising rates, we had higher oil prices, and they just went too far, and eventually it had a recession. Our forecast is not for a recession in the United States. Our forecast is that we'll have a mid-cycle slowdown in 2027."
