Who is right: the US Fed or the bond markets?
The US Federal Reserve has hiked its fed funds rate three times aggregating to 75 basis points in just the past six months. Yet, treasury yields have hardly budged from where they were when the rate hiking cycle began in December 2015 and are lower than where they were in December last year (see chart). The Fed seems confident that despite risks of inflation undershooting the 2% target, prices would get there in the medium term. This made the central bank reiterate its March forecast of three quarter-percentage-point hikes for 2018. The Fed also detailed a plan to unwind its balance sheet through monthly asset sales. Yet, the 10-year benchmark US treasury yield fell 10 basis points in offshore trade after the Fed rate hike. Is it that the market has decided to ignore the Fed because they are sceptical about inflation? Indeed, the Fed has pruned its inflation forecast for core inflation in 2017 from 1.9% at its March meeting to 1.7% now. Traders are choosing to see the hard data.
In emerging markets like India, the story remains the same. It wasn’t long ago (in 2013) that emerging markets were pummelled after the Fed first indicated that it would start looking at unwinding. The infamous taper tantrum hasn’t seen an encore though. The 126 basis points fall in Indian bond yield and the surge of 23% in the Sensex since December 2015 pours cold water over fears of dollar outflows as a result of the Fed raising rates in the US. Since January this year, investors have poured close to $20 billion into Indian stocks and bonds.
As the chart shows, yields in India, thanks to much lower inflation, a lower RBI policy rate and abundant liquidity, have been falling. Notwithstanding the problem of bad loans and overleveraged corporate balance sheets, economic growth is expected to pick up pace and the India premium over other emerging markets in the stock markets is intact. Inflation is well under control in India and in most emerging markets, it is on a downward trend. The yield differential between US and Indian bonds continues to be very high. A relatively stable rupee is adding to the allure of the Indian markets.
The fall in bond yields, both in the US and India suggests that traders are seeing slower rate hikes (in the case of the US) and rate cuts (in the case of India). A look at the central banks’ statements, however, would give a complete different outlook. It will soon be clear whether the central banks or the markets are right.