Why are rising US Bond Yields hitting Indian Markets

Why the spike in US Bond Yields

Just around June 2023, the US bond yields were at a comfortable level of 3.5%. Between June 2023 and October 2023, the US bond yields surged vertically to around the 4.99% levels before settling at around 4.85% levels. However, the global markets are rife with expectations that the US bond yields will eventually cross the 5% mark and settle above that mark. Whether it really happens or not, only time will tell. 

There are two issues that arise here. Firstly, what is the reason that bond yields have risen so sharply in the US in last few months. Remember, US bond yields are already at the highest level since 2007. The second question that arises is if the bond yields in the US are actually at a 16 year high, then why is it having such a deep impact on Indian equity markets. Is the link between a spike in US  bond yields and fall in Indian equities purely incidental? Incidentally it is not coincidental!

You may also want to know about Stocks Under 20 Rupees in India

Table of Contents

1. Why the spike in US Bond Yields
2. Why are US Bond Yields rising rapidly?
3. Why is the US Bond Yield spike hitting Indian Equities

Why are US Bond Yields rising rapidly?

The spike in US bond yields wasn't unexpected, but the speed and intensity have surprised markets. The 10-year yield jumped from 3.5% in June to nearly 5%, even as the Fed signaled a pause in rate hikes. While the Fed may not raise rates further, it has clearly indicated that rates will stay elevated through 2024, dashing hopes of early rate cuts.

One reason for the yield spike is a sharp sell-off in bonds. Traders who had bought bonds expecting rate cuts were disappointed, leading to falling prices and rising yields. With the Fed holding rates steady and withdrawing liquidity, bond supply has outpaced demand.

Another factor is that corporates now face refinancing at much higher rates amid tight liquidity, pushing yields up. Lastly, the bond market is adjusting the yield curve—after a prolonged inversion, 10-year yields are rising to normalize the spread with 2-year yields.

Why is the US Bond Yield spike hitting Indian Equities

A spike in the US bond yields tend to spike in Indian bond yield too. That has been evident for some time now. Here is why it is negative for Indian markets.

• A spike in US bond yields, would force Indian bond yields to also rise in tandem for Indian bonds to remain competitive. At the end of the day, Indian bonds have to maintain their real rates at a level that can compete with other economies.
   
• A spike in Indian yields also raises the solvency story for Indian companies. Indian companies have, in the recent past, seen a sharp spike in funding costs. This can be especially negative for companies with a high degree of leverage.
   
• The third and rather interesting relationship is the debt / equity parity. Let us understand this point. At the current P/E of the market at 20X, we are looking at 5% earnings yield on equities. With debt at 7.4%, the equity yields are already losing competitiveness. It has to result in either equity markets correcting or bond yields tapering sharply. The former looks a more likely scenario.
   
• The fourth reason rising bond yields is hitting equities is that it raises the effective cost of capital for Indian companies. Indian companies are valued based on future cash flows, that are discounted to the present. This discounting is done based on weighted average cost of capital (equity and debt). A spike in bond yields will also increase the required return on equities and depress the valuations due to the higher discount rate.
   
• Lastly, there is the dollar impact one cannot ignore. Rising bond yields in the US means continuous flows of capital into the US. Rising bond yield normally make the dollar stronger as is evident from the dollar index. That has the impact of weakening the rupee and the RBI can intervene only upto a point. Weak rupee not only means more imported inflation but also hits dollar returns of portfolio investors; making FPIs wary of investing in India. That is evident in persistent FPI selling.

The moral of the story is that rising bond yields in the US are impacting Indian stock markets negatively.