Global bond yields continue grinding higher, with a new leg up over the past few weeks. Proximate drivers for this have been renewed pressure in the energy market and stepped-up hawkishness from key developed market central banks. As an example, the Fed has recently surprised markets regarding the extent of its hawkishness. More fundamentally, however, US nominal growth rate has been strong and is accelerating again. This is even more remarkable given the ongoing energy price shock and is largely owed to the private capex cycle courtesy the AI buildout. Thus, the Fed needn’t for the time being worry about demand destruction from the commodity shock but instead can focus almost exclusively on the inflation mandate where it has missed target for more than five years now. Further, strong demand conditions make it more likely that companies will be able to pass through higher input costs. Another potentially developing source of inflation could be that US labour demand may be rising again in an environment where supply is severely constrained. While still very early days, one needs to see whether this starts reflecting in wage growth as well. If so, then that would constitute an additional source of pressure on inflation and for monetary policy in the US.
Apart from the above, the other pressure on global yields is the rising supply of bonds. Thus, while higher developed market fiscal deficits were the dominant theme for bonds till last year, it is now the incrementally debt funded build out of AI capex.
The chart below highlights two important points, one medium term and the other shorter term.
As can be seen, US nominal GDP growth averaged 4.1% over 2011 to 2019. This has moved up to 6.2% over 2020 to 2026 so far. The latter period includes both the pandemic drawdown as well as the reversal from that. While the first part of the post pandemic growth boost was from aggressive fiscal loosening and very supportive monetary policy, the narrative now has rotated into private capex growth related to AI, even as underlying fiscal dynamics remain relatively loose. This leads to the shorter-term point: nominal growth rate had begun coming off over 2023 – 25 as the post pandemic stimulus faded. However, with new growth drivers now emerging from AI capex, it is rebounding again over 2026 so far. Indeed, concurrent and forward-looking indicators seem to be pointing to further incremental economic strength including spillover into labour demand.
The next point is as follows: the latest rise in bond yields is not owing to market incrementally getting more concerned with inflation. Rather, most of it is due to the so-called ‘real yields’ rising. This is shown in the chart below.
This is thus far running contrary to the generally held belief that to manage its large fiscal deficit, the US will implicitly aim for lower real yields on its bonds. To be fair, higher real yields may be despite US government efforts to the contrary. However, the point remains that real compensation has had to rise. This in turn seems connected to the same two points made earlier: economic growth rates are higher and competition for global capital is more intense, both implying that real yields need to be higher. Further, so long as higher yields are not causing broad-based economic damage, there is no reason for the market to call a ceiling on these yields. On this point, the interest rate sensitivity of AI capex seems lower at least so far compared to say housing. Thus, one is seeing a stagnant US housing market co-existing with rising aggregate economic growth rates.
The next point pertains to the Fed. With the last FOMC meeting, market has shed all doubt that the Fed won’t be credible with respect to meeting its inflation goals. This has helped build rate hike expectations of a further 75 – 100 bps, much more than what the revised so-called ‘dot plots’ seem to be indicating. This may be owing to a variety of reasons: 1> market pricing reflects tail event probabilities as well which are aggregated into the averages 2> the Fed chair doesn’t believe in providing dot plots or forecasts thereby leading the market to de-emphasise the dot plots generally 3> Fed inflation commitment combined with ongoing economic strength and commodity price shock may be leading market to believe that more rate hikes will be eventually needed than what FOMC members are currently projecting.
Basis the above, the US yield curve is flattening again as the chart below shows.
Traditionally, a flattening leading to eventually inversion is considered a sign of weaker economic growth. However, this signal had failed most recently over 2022-23 as the chart shows. Also, the curve is far from inverting just yet. For the time being we, and the market, are more guided by concurrent data which seems to be suggesting continued acceleration in US economic activity.
Basis rising real yields, robust economic activity, and renewed Fed credibility, the dollar index has been rising again as seen in the chart below.
For net energy importing and current account deficit emerging markets like India this adds additional stickiness to the situation. Thus, while the recent FCNR flows have provided near term cushion, one cannot help but note the extra-ordinarily hawkish global environment. The RBI so far has kept liquidity abundant and not touched repo rate, focussing on the very muted core inflationary pressures as its guidepost.
As the chart above shows, India’s average nominal growth rate has shifted lower. This reflects a more prudent pandemic stimulus that focussed on sustaining macro stability and a timely return to a long term sustainable fiscal stance. More recently, the relative tailwind to private capex has been more muted here compared with, say, the US. However, one can see nominal growth acceleration in India as well.
The above difference in dynamic also somewhat helps explain RBI’s easier stance on monetary policy thus far: fiscal policy has been well anchored and private capex tailwinds have hitherto not been as strong thereby allowing the central bank to try and keep monetary conditions easier for longer. However, three points nevertheless are of note: One, the so-called ‘impossible trinity’ issue that we and others have spoken about for so long has prevented market rates to follow RBI policy rate for more than a year now. Two, one can see broad-based inflationary pressures in play now including from energy prices, transportation costs, and weather shocks. Three, it remains a global race for attracting capital where developed market real rates have generally been moving up. As a current account deficit country, we must compete for foreign capital as well. Therefore, the degrees of freedom available to run a lower real rate regime may be limited for us even as local growth-inflation dynamics may very well be able to argue for the case.
Summary and Takeaways
Global neutral real rate setting seems to have moved up reflecting stronger nominal growth in key developed markets like the US and intensifying competition for global capital courtesy the AI buildout. The growth acceleration seems even more remarkable given the ongoing commodity price shock and owes much of its resilience to private capex linked to AI which, at least for the time being, seems less interest rate sensitive. The Fed has regained any intermittent loss in credibility and seems now completely focussed on a timely return to its inflation target. With growth robust, and probably accelerating more recently, the Fed can afford to focus almost exclusively on the inflation mandate. This is getting reflected in market’s rate expectation, as well as recent flattening of the yield curve. The rise in bond yields thus far has not come in the way of robust economic growth. With a volatile commodity price backdrop and still loose US fiscal dynamics, there is therefore little anchor for the time being on yields unless one starts to see some visible signs of ‘breakage’.
The recent upturn in the dollar, alongside broad-based commodity price pressures, is a fresh headache for RBI. Even though local dynamics may be somewhat different, India must compete for the same pool of capital and thus local rate dynamics must respect the rising global neutral rate settings. Note, this is an argument for traditional macro-policy but with more limited degrees of freedom given the global context and not the extreme one of using rates for currency defence. To be clear there is no case in India for doing the latter. Nevertheless, even viewed from the more traditional lens there is considerable monetary tightening that RBI may have to undertake in the months ahead should no turn come to the global commodity and real rate dynamics as reviewed here.
As at the time of writing, we remain conservatively to very conservatively positioned on duration risk across a host of our fixed income funds. As always, this reflects our current view and thinking and this may change at any point going forward.
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