Bond yields are an important reference for studying economic sentiment and monetary policy direction. In the past years, mainly from June to October 2023, US bond yields have experienced a sharp rise from about 3.5% to almost 5%. This quick rise has not only rocked worldwide financial markets but has also instigated significant corrections in emerging equity markets, India being a prime example.
The correlation between increasing US bond yields and decreasing Indian equities is definitely not by accident; the economic and financial relationships are visible. In this article, we look into the reason for the sudden surge in US bond yields and why it is being felt negatively in the Indian stock market.
Why Are the United States Bond Yields Affected So Quickly?
The performance of the US bond yields was mainly expected, but what caught the market by surprise was the momentum and extremity of the influx. Let’s examine why this trend is gaining traction:
1. Federal Reserve’s Long-Term Hawkish Approach
While there have been expectations of rate cuts, the US Federal Reserve has adopted a hawkish approach. According to the latest FOMC minutes and public comments from Fed Chair Jerome Powell, interest rates will remain high far into 2024. The Fed has leaned towards a “higher for longer” policy rather than overreact and cut rates.
Markets had anticipated a sharper shift to rate easing, this resulted in aggressive bond buying. Once that pivot did not materialise, the tone turned squarely negative, and a tornado-like sell-off ensued in bonds. This sell-off sent prices down and yields up because of their inverse relationship.
2. Shattered Expectations of Capital Gains
The majority of bond traders were heavily invested in US bonds, looking for declining rates and their subsequent price increases. Nonetheless, with the Fed maintaining rates and predicting a prolonged degree of inactivity, these positions became unprofitable. This outflow from bonds increased the supply to the market, further depressing prices and pushing yields higher.
3. Tight Liquidity and Corporate Borrowing Pressures Concern.
Tightening liquidity is another factor contributing to the yield spike. The Fed has already withdrawn more than $1 trillion of stimulus from the market. Concurrently, corporations are now pressured to refinance their debts at a high rate of interest, thereby intensifying pressure on bond markets. The need for bond replacement is growing, and with higher borrowing costs, the yields on newly issued corporate and government bonds are rising to reflect higher risk and demand.
4. Yield Curve Normalisation
In 2022 and early 2023, the US had an inverted yield curve, which is when the short-term bonds’ yields (2-year, for example) were above the long-term yields (10-year, for example). This discrepancy usually indicates an uncertain economy. As clarity grew regarding the Fed’s view, the Curve started rectifying itself, lifting long-term yields sharply, bringing back normalcy, and reflecting realistic long-term IOBE.
Why Are Indian Equities Reacting to US Bond Yield Spikes?
The rise in US bond yields has had a heavy impact on equities in India. This global shift is coming to the Indian market via the following key channels:
1. Pressure on Indian Bond Yields
When US bond yields go up, then Indian bonds have to be more attractive so that they can compete. Global investors evaluate the real reward (in terms of inflation and currency risk) of investing in emerging markets. Capital flows may go to the US if Indian yields do not follow such trends, which may trigger capital outflows in India. To mitigate this event from happening, Indian bond yields must also go up, thus increasing borrowing costs in the domestic market.
2. Increasing Rate of Capital for Indian Corporates
Higher domestic bond yields imply more expensive borrowing for India’s companies. Highly leveraged, or capital expenditure planning firms, suffer from financial problems. As the cost of borrowing increases, the corporate profit margins decrease, and thus the value of equities goes down.
3. Equity vs. Debt: The Risk Premium Narrows
With prevailing levels, Indian equity markets trade at price-to-earnings ratios of just about 20x, and this translates to around a 5% earnings yield. When yields of government bonds are at or higher than 7.4%, the premium of equities reduces. Investors are more likely to shift devotees to risk-free, fixed-income securities, particularly after being adjusted for risk and return. This rebalancing decreases the equity demand and brings the market to a correction.
4. Discounting Future Cash Flows
Stock prices are usually calculated on the back of discounted future cash flows. Typically, the rate of discount used is that of a company’s weighted average cost of capital (WACC), which also includes debt and equity. A spike in bond yields increases this discount rate, which decreases the present value of future earnings, and stock valuations suffer across sectors.
5. Strengthening Dollar and FPI Outflows
The most glaring effect has been in the currency and the capital flows. Increased yields on US bonds make the US dollar more potent because global funds then go for higher yields. This makes the dollar index stronger and simultaneously the Indian rupee is weakened, thus leaving India unappealing to foreign investors.
Foreign Portfolio Investors (FPIs), which have substantial holdings in Indian equities, are frequently forced to withdraw from the market on such terms. Their continued selling pressure causes even more depreciation in stock prices and volatility in market sentiment.
Conclusion
The surge in United States bond yields is a sign of tighter monetary policy, a higher dollar expectation, and a change in market psychology regarding rates. The peak was at least expected, but the rapidity with which it occurred surprised investors.
The ripple effects are profound for Indian markets. As a result of this global shift, Indian equities face multiple headwinds, including tighter liquidity and costlier capital, weaker foreign investor appetite, and valuation worries.
For investors, the underlying message is to follow global macroeconomic indicators, especially US bond yields, since they drive the direction of emerging markets to a large degree. The future of Indian equities before the road ahead may continue to be bumpy until the bond markets stabilise or the rate cut expectations re-debut back on the table.
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