The resource curse (or the paradox of plenty) has been known to affect many emerging and frontier market countries with an abundance of natural resources.

Developed countries with their entrenched democratic systems and values, seemed to be free of this, at least until now. Unfortunately, their exploitation in recent years of a single unique resource of theirs — the ability to print money at will as domestic and global investors lapped it up — appears to be now making them prey to same resource curse.

At least that is the message that the surging bond yields in developed markets are signalling. With the US 10-year treasury yields nudging at the peak levels reached in October 2023, that had then wrought pressure on global stock markets, doubts are now cast on whether the US Fed rate cutting cycle has been aggressive.

This argument gains further strength given the high fiscal deficit of the US government and loose financial conditions as reflected in surging equity markets and low corporate bond spreads.

Fool in the shower

The US Fed faced considerable embarrassment for calling the surging inflation of 2021 as transitory, until it was too late to make amends. Now it faces the risk of its interest rate cuts turning out to be transitory as well! On Friday, after a very strong US jobs data for December, analysts trimmed their US Fed rate cut expectations for 2025, with Bank of America Global Research going a step ahead and noting the rate-cutting cycle is over and that inflation is now stuck above target with upside risks. In its view, the conversation could move to rate hikes if the inflation exceeds 3 per cent.

Nobel economist the late Milton Friedman had likened central banks in haste to the ‘fool in a shower’. According to him, when they overreact to data points, they end up like the person in a shower turning on hot water tap when he realises the water is too cold, but since hot water takes time to flow, turns the tap too much, scalding himself! And in reaction to this, as the person closes the hot water tap, the water gets freezing cold again!

Some now fear that the US Fed may have over-reacted with its first 50 bps interest rate cut in September 2024, possibly in reaction to the scare caused in early August 2024 by the squeeze in USD-JPY and unwinding of some Yen carry trades roiling global markets.

One of most unusual things to note in the current US rate-cut cycle has been how the long-end rates have actually been moving up since the time the US Fed embarked on the rate-cut cycle.

Fighting the Fed

It is warned not to fight the Fed given the enormous resources at its disposal to achieve what it targets. But this is precisely what the bond vigilantes have been onto. Between September 2024 and now, the Fed Fund rates have been cut by a full 100 basis points.

During this time, the US 10-year treasury yield is up the same 100 basis points! Such contrarian movements have not happened in the last 40 years.

For many crucial sections of the economy like housing, the long term rates matter more than the short-term Fed Funds rate. The investors in long-term bonds have been indicating for a while now that they are not convinced the US Fed inflation target of 2 per cent will be realised and hence been demanding higher term premium for long-end bonds. As an old maxim goes ‘if central banks don’t do their job, the markets will do it for them.’ High fiscal deficit and resultant issuance of bonds have enhanced the pressure on yields.

Further bond yields are surging not only in the US, but across many markets. Ten-year yields in Japan and the UK are at their highest level in 14 and 17 years, respectively. The yields in the UK are now above the levels they had touched during the UK gilt crisis, also known as the Liz Truss moment, of September 2022.

Concerns are gradually building that if developed market governments don’t get their fiscal deficit and rising government debt in order, the Liz Truss moment can play out for them.

In an environment where bond yields are soaring, cooling bond yields must be welcome. But this is not the case when the bond yields are declining to such an extent as in China, reflecting deep concerns of its economy. Last week 10-year bond yields in China reached the lowest levels ever of 1.65 per cent. And it would be worth noting that along with these extreme moments in global bond yields, the USD-JPY is nearing the levels close to which the Japanese Central Bank intervened in the currency markets to defend the Yen , that subsequently resulted in global stock market volatility in August.

Volatility ahead

The bond market tantrums can flow through into equity markets as well if investors start fearing higher yields are going to persist. Higher risk-free yields make risk assets less attractive.

According to Warren Buffet, high interest rates act like gravity on stock prices.

Amid relentless FPI selling in recent months, equity investors in India will have to factor these global factors, too, apart from the ongoing domestic earnings slowdown. In the past 5 years every dip has been a buying opportunity, but this dip appears to be facing more challenges than the previous ones.