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!
Why are US Bond Yields rising rapidly?
It is not that the spike in bond yields in the US was not expected. However, it is the pace and the ferocity of the rate hikes that has spooked markets. The 10-year bond yields in the US were at 3.5% in June and has since spiked to 4.99%. That is a very sharp rise in a short span of time and this comes at a time when the US Fed is planning to go slow on rate hikes. What explains this dichotomy?
- If you read the minutes of the US Fed meet or browse through the speeches of Jerome Powell and others, it is clear that the Fed is not done with its hawkish stance. The Fed may not be too keen to hike the rates much further from the current range of 5.25%-5.50%. However, the Fed has indicated that it would be on pause model for much longer. The long term estimates indicate that even by the end of 2024, the Fed rates would still remain above 5%. That means that rate cuts are unlikely to happen at the same pace as was anticipated in the past.
- That brings us to the second reason for the spike in US bond yields. Bond yields are inversely related to the bond prices. That means if yields rise, then bond prices fall and vice versa. However, what is more interesting is that the cause effect relationship between yields and bond prices work both ways. Either of these factors can occur independently and trigger change in the other. For instance, many bond trades had aggressively bought US bonds in the last few months hoping that rate cuts would boost bond prices and result in capital gains. However, the Fed disappointed these traders by committing to hold rates for longer and ruling out rate cuts for the next one year. This lead to a massive sell-off in US bonds and as prices of bonds fell due to excess supply, the bond yields went up in proportion.
- The third reason for the spike in the bond yields in the US was the expectation that the pressure could come up as corporates renew their loans at higher rates. This could get accentuated as liquidity is already tight due to the Fed already withdrawing $1 trillion of stimulus from the market. This process of corporates borrowing at higher rates in the market amidst tight liquidity is one more reason for the spike in yields.
- Lastly, there is a yield curve adjustment that is also happening. Over the past year, the US market repeatedly saw a negative yield curve as the 2-year bond yields exceeded the yield on the 10-year bond yields. This situation is anomalous but was reflective of the uncertainty in the market. Now the Fed stance is clear as is the trajectory. With clarity emerging, markets are betting that 10-year bond yields should spike to defend the spread with the shorter tenure bonds.
So, while the US bond yields have spiked in a surprising manner, it seems to be a long pending adjustment. But what does that mean for India and why?
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.