What is the relationship between the bond and equity markets?
Intuitively, the relationship seems to be inverse— when bond markets do well, equity prices tumble. For instance, during the last downturn in 2000-03, while banks made lots of money by investing in bonds, the equity markets were depressed.
During downturns, credit growth slackens because the economy is slowing and there’s usually surplus liquidity with banks, which they use to invest in government bonds. That results in a bull market in bonds, while the slowing economy pulls down earnings growth and affects the stock markets.
Robert Buckland, Citigroup Inc. strategist, has analysed the relationship between bond yields and stock markets in developed countries. He finds that: “When bond yields are low, the correlation between the assets tends to be negative—what is good for bonds is bad for equities. This is when uncertainty is extreme, risk premia are rising and deflation fears set in.
When bond yields rise from very low levels, these concerns are unwound and we find what is bad for bonds and is good for equities. Investors start their migration from safety, as we are experiencing right now.
“Conversely, at high bond yields, what is bad for bonds is also bad for equities. At these levels, risk appetites and growth expectations are already high and will not be able to counter rising bond yields. Rather, higher bond yields may be a prelude to tighter policy and lower growth expectations.”
In other words, much depends on the level of interest rates. Buckland’s observations explain the current scenario in the US and other advanced countries, where rising bond yields have been accompanied by rising stock prices. That’s because yields are still comparatively low. Although long bond yields have shot up in the US as the markets worry over the huge expansion in money supply by the US Federal Reserve, the 10-year yield is still well below 5-6%, which Buckland says is the historical level beyond which bond and stock prices start moving in tandem, i.e., higher yields, which mean lower bond prices, will hurt stocks above that level.
What about the Indian market? Bond prices have moved down while yields have gone up in the last few months, even as stocks zoomed. Could our markets too be at the same stage as developed markets, when bond yields and stocks rise together?
But Buckland has a different take on that. He says, “In contrast to current developed market experience, we find the correlation between emerging market bonds and equities has remained strong and positive at all yield levels. Emerging market bond yields have never declined below the 5-6% threshold when correlations start working in reverse. Inflation and sovereign risk premiums haven’t been low enough. What has been good for emerging market bonds has always been good for emerging market equities. As risk appetites rise, money flowing out of developed world bonds has found a new home in riskier assets like emerging market bonds and equities. This suggests investors should remain overweight emerging markets as bond yields, risk appetites and growth expectations continue to normalize from here.”
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