Graphic: Mint
Graphic: Mint

Are rising US bond yields bad for Indian stocks?

For investors in India, with the US dollar strengthening and the rupee weakening, US assets become more lucrative

The US Federal Reserve is in a hawkish mood. Fears of tighter liquidity have led to massive selling in emerging markets (EMs) by foreign investors and India has been no exception.

The theory is pretty simple—as yields rise in the US, investors flock back to US markets. This leads to weaker EM currencies, depressing dollar returns for foreign investors in EMs.

For investors in India, with the US dollar strengthening and the rupee weakening, US assets become more lucrative.

But that’s the theory—in practice, as Chart 1 shows, things turned out rather differently during the bull run of 2003-07. The chart indicates that back then, both US 10-year yields and the Sensex moved up in tandem.

The usual explanation is that when economic growth is strong, markets don’t mind monetary tightening. The Fed has also been accused of tightening too little during the boom of 2003-07, which inflated the bubble and ultimately led to the spectacular bust of 2008.

Now consider chart 2. This time too, the monetary tightening has proceeded by baby steps, with care being taken not to rock the markets. Why then the exodus from EMs?

Global growth has picked up this time too, but perhaps there’s a realization that growth has been purchased by pressing down interest rates to ultra-low levels and a rise in interest rates could hurt growth.

There is also no shortage of other worries. Trade tensions are rising, debt levels are elevated, as are stock valuations in several markets.

For India, there are plenty of concerns. Valuations are high and the exodus from the bond markets has weakened the rupee. At the same time, domestic inflows have supported the equity markets, which wasn’t the case last time around.

Deepak Jasani, head (retail research) at HDFC Securities Ltd, said, “The US Federal Reserve raising rates, followed by rising bond yields, is a positive sign especially for the US economy. For India, FIIs (foreign institutional investors) inflows have remained muted for quite some time now and DIIs (domestic institutional investors) have been key drivers. Also, the Fed is expected to gradually raise rates, which may not be disruptive for Indian markets. That said, if FII selling in Indian equities accelerates not just because of interest rate movements in the US but some other negative development in emerging/European markets—it will become a concern. But for now, investors in equities need not lose sleep over it."

That said, domestically, there are other concerns, which can weigh on the stock market’s performance. These include political uncertainty, rising bond yields and a struggling banking system. Could the relationship between US bond yields and the Sensex be different from the 2003-07 experience this time around?