NEW DELHI: Bond yields are hardening globally, sending panic wave across global equities.
Dow Jones lost a jaw-dropping 666 points on Friday after 10-year Treasury yield rose some 2.8 per cent to hit the highest level since January 2014. As of Monday morning, the BSE Sensex is off nearly 1,700 points from its all-time high of 36,443, while midcap stocks were bleeding even more.
Analysts are attributing this fall to rising global bond yields, which have unsettled investors and central banks the world over.
Last week, rising bond yields prompted the Bank of Japan (BoJ) to intervene in the bond market for the first time since July last year.
India, too, is witnessing a rise in yields on 10-year bonds, and the Dalal Street is feeling the heat. The Reserve Bank of India cancelled a scheduled bond auction on Friday, triggering a relief rally in the bonds, which had climbed a 23-month high a day earlier amid concerns over higher-than-expected fiscal deficit projection for the next financial year.
But why are rising bond yields hurting equities?
Take the Indian context. India's 10-year bond yield hit 7.56 per cent per annum on Friday, up 115 basis points from 6.41 per cent it quoted at the end of July 2017.
When bond yield rises, the opportunity cost of investing in other assets, including equities, rises. This makes stock investments less attractive.
Bond wins over equity
Opportunity cost is nothing but the cost of next best alternative - the cost of foregoing one investment option in favour of the other. In this case, it is the difference between returns offered by equity and that by bonds.
Equity investments are deemed risky. To take that risk, one would certainly seek a risk premium over risk-free or less risky assets such as bonds. Given that the market is still trading near all-time high level - despite the recent correction - on mere earnings revival hopes, one may, for example, seek that 'risk premium' at 6 per cent.
At prevailing bond yield of 7.56 per cent, one would then require 13.56 per cent (adding 6 per cent risk premium) on equity to make a switch from bonds. The more the bond yields rise, the more will be this opportunity cost.
Now let us look at the trailing market valuations (P/E) and bond yields. A PE ratio of 24.53 for BSE Sensex on Friday suggested that investor were willingness to pay Rs 24.53 for every Re 1 of Sensex earning. Now if you reverse PE (i.e. 1/24.53 or 4.07 per per cent), you get what is called the earnings yield.
If equities are offering a yield of 4.07 per cent and 10-year bond 7.56 per cent, one would understand why money is moving away from equities. The BEER ratio (bond yield/equity yield) now stands at 1.85, suggesting that equities are overvalued.
Hope rally created contradictory trend
The recent strengthening of stocks in India despite rising bond yields suggested that the market was expecting a strong earnings recovery.
Kotak Institutional Equities in a recent note suggested that the market was overlooking the rising yield on some 'misguided view' about earnings and macro-economic factors being less relevant to the equity market against ample global liquidity.
What is making bond yields rise?
The sharp increase in bond yields in India over the past few weeks has been attributed to investors' concerns about the fiscal slippage in FY18 and a higher-than-expected fiscal deficit target for FY19. A higher fiscal deficit leads to a spike in government borrowings, especially when government's revenue generation has been sluggish. There are also inflationary concerns, following the Budget proposal to raise minimum support prices (MSP) on crops.
Simply put, when a country's macro-economic situation deteriorates, bond prices fall and bond yields rise, as investors seek more return on bonds to compensate for the risk involved.
That was the reason why bonds yields had soared in many European economies such as Italy and Greece during the debt crisis a few years ago.
Rising inflation isn't always a bad thing. But it certainly prompts central banks to take monetary action, which reduces liquidity in the system.
"The cause of this correction is the ostensibly withdrawal of liquidity by central bankers, and consequently rising interest rates. Central banker have nurtured the world economy to the general ward from the ICU. They got a lot of steroids of liquidity and low interest rates and refinancing, whereby US Fed picked up every junk subprime loan in the market. European Central Bank too picked up even junk bonds from various countries. Now they are saying we will take out the steroids, because it could have side-effects," said Nilesh Shah, MD at Kotak AMC.
Jim O'Neill, Former Commerce Secretary in the UK government, on Monday said the US is growing and the central bank may need to tighten monetary policy faster than the market has perceived.
Friday's employment data was strong and, in particular, wages growth is starting to accelerate in the US, which means that the Fed may have to raise interest rates more and as a result bond yields may rise even more significantly.
Equity markets are suffering some competition in terms of investors for the first time in many weeks, he said. In the US, recent economic data, including Friday's wage growth and inflation, has been positive. A stronger economy generally strokes inflation. A rise commodity prices also raises inflation.
Of late Brent crude prices have been rising and brokerages like Goldman Sachs project the prices to top $80 a barrel in six months. To fight inflation, central banks go hawkish on interest rates.
There are speculations that the US Fed may turn hawkish, if inflation hits the the target of 2 per cent growth. Inflation has an inverse relation with bond prices, and positive relation with bond yields.
"We have seen the US Fed warning the markets that it would be raising interest rates. It is preparing markets for two-to-three rate hikes, so that it can actually deliver one or two. There is no doubt interest rates will rise and liquidity will be withdrawn but it will be gradual and calibrated in nature," said Shah of Kotak Mutual Fund.
There is no thumb rule though
Rising bond yields do not always lead to poor equity performance. In its recent CIO Investment Insights - 2018, DBS noted that between December 1998 and January 2000, the US Treasury (UTS) 10-year yield rose 202 bps and the S&P 500 index correspondingly gained 13 per cent.
Similarly, between May 2003 and June 2006, a 177 bps surge in the UST 10-year yield failed to deter US equities from notching up 32 per cent gain. In recent times, India's equity indices rallied to record high levels despite a steady spike in bond yields.
So if you still think a 10 per cent long-term capital gains tax is what is hurting Dalal Street? Think again.
By
Amit Mudgill
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