Most of the year so far has been about trying to find policy rate peaks in major developed markets (DMs). Expectations here have been continually frustrated thus far as inflation has proven much more resilient than was being previously expected.

There was one plateauing of expectations around the middle of June, post which rate forecasts were actually reduced under the mistaken impression of policy pivots. The illusion was broken by September as a spate of ugly inflation prints drove peak rate and peak inflation theses to the waste paper bin. This set the stage for a further leg higher in DM rate pricing and, contrary to many expectations (including our own), a meaningful one.

The frustration here, macro-economically speaking, has been that while signs of economic breakage have abounded, they nevertheless haven't been widespread and consistent enough to arrest the pace of DM central bank tightening.

Thus, for example, even as the housing sector continues to bleed in the US, overall growth seemed to have bounced back smartly in the third quarter. The downshift in the jobs market is evident, but the relative tightness has refused to ease much so far, and although wage growth pressures have eased somewhat, they still are more elevated than what is consistent with 2 per cent overall inflation.

A key reason for this, one that was always in play but the potency of its effect was hard to quantify, is just the nature of the pandemic-response fiscal stimulus in the US. Unlike the post-Global Financial Crisis fiscal expansion, a significant part of the pandemic stimulus involved direct cash transfers to members of the public.

The quantum involved was large enough to provide strong safety cushions to consumers for a length of time. This has possibly delayed the transmission of rate tightening to growth and inflation in two ways: One, consumer demand has been more resilient to higher prices. In fact an important discussion in the US today is that company margins are still unnaturally high in general, and are a key contributor to concurrent inflation.

Thus there was already a cost-push aspect owing to Covid and the Ukraine war, but there is an additional build-up due to companies passing on more than just cost escalations. Two, there may be more near-term headwinds to labour supply, ceteris paribus, with higher safety cushions now in play for employment seekers.

Whatever be the reasons, the fact remains that the Fed needs definitive evidence of softening from the labour market, and this hasn't been forthcoming thus far. It is to be noted, though, that while the rate thresholds may have increased for tightening and transmission lags may be longer partly for the reasons discussed above, the process itself is likely to be alive and well.

Additionally, the pace of this tightening cycle in major DMs has been unprecedented, and financial conditions have tightened significantly over a relatively short period of time, so the lagged impact of this on economic activity could also then be, ceteris paribus, higher. The question then, and one that inevitably rings a feeling of deja vu, is this: has enough been priced in on terminal rates now?

The key source of imported tightening for emerging markets (EMs), including India, for most of this year has been on account of the rise and rise of the US dollar. This in turn has been triggered by the continuous higher reiteration in US terminal rate expectations, and the associated rise in bond yields, the dynamics of which have been discussed above.

Even accounting for our view that the RBI needn't be lock-step with the Fed, our expectations from the terminal RBI repo rate have had to take into account spillover risks from abroad. This has led us to now expect a higher peak repo rate than what we believed, say, in September.

For the world to begin to stabilise, the dollar has to give its approval. Therefore, the incremental sensitivity of the dollar to evolving data is of much relevance. Here, there is tentative good news. The US two-year bond yield (loosely signifying policy rate expectations in the current cycle) touched a fresh year's high recently -- and the dollar index is appreciably lower than where it was in late September.

This has also to do with the relative hawkishness of other DM central banks, but many of these (barring maybe the ECB) seem to be lately more appreciative of two-way risks to their incremental tightening cycle.

Further, even the Asia Dollar Index seems to have not been responding to the last leg of the rise in US yields and rate hike expectations.

We have argued in the past that the RBI need not be in lock-step with the Fed. Subsequently, two external members of the RBI's MPC seem to have echoed our logic, with both likely to vote for a pause in the upcoming December policy (even as we still expected a final 25-35 bps hike in December). A third external member was still hawkish, but will likely vote for a scaling down on the pace of normalization (that is, vote for less than 50 bps hike).

An internal RBI member was debating 35 bps or 50 bps for the September meeting itself, which seems to suggest he would be unlikely to vote for a full 50 bps in December. The one caveat is that these observations are based on their last heard views which may have undergone modifications by now.

A possible reason for some modification, apart from Fed rate expectations having gone further up (though it may not be material for two external members), is that India's local food inflation pressures have inched up. On the basis of available data, our own forecast of the October-December average Consumer Price Index (CPI) is around 40 bps higher than the RBI's projection of 6.5 per cent.

It is possible that there has been some upward shift in our own terminal repo rate expectations on the basis of the above. The bigger point though is that so long as the terminal is 6.50 per cent-centric, it can be argued that sovereign bond valuations at the front end have largely adjusted for this.

This will be especially true if imported volatility starts to subside for reasons mentioned above and if, going forward, our recent observations in this regard hold.

In fact, the evolution of Indian bond yields has been quite interesting thus far. The bulk of upward adjustment actually happened in the short period between April and June as the market repriced the change in the RBI's reaction function. Unlike many of their DM peers, Indian yields haven't gone higher than their June highs, save for at the very front end, which was to be expected as the rate cycle progressed. Indeed, while yields in the five-year segment are similar to what they were in mid-June, those in the 10-year and beyond are actually lower.

It is to be noted, however, that though we expect the peak RBI-to-peak Fed differential to be lower in this cycle, we expect the differential to open up again over the time ahead. As discussed above, the Fed is peaking much higher than long-term neutral. This is owing to much-higher-than-usual inflation, the bulk of which is presumably cyclical.

As inflation starts to come off, the Fed policy rate will also start to move towards neutral over the next couple of years. On the other hand, since the RBI is peaking not far from neutral, it may have to hold rates there for longer.

Thus some of the market's rate differential concerns may get addressed not by the RBI being in lockstep with the Fed now, but rather it holding the rates at peak for much longer than the Fed. That said, the market may still respond by compressing the term premium between front end rates (up to five years) and the policy rate during this period.

Again, however, this is possibly trying to look too much into the future. For now one is only watchful for signs of volatility stabilising at a valuation which is quite comfortable so far as government bonds up to five years' maturity are concerned.