US 10-year bond yields near 16-year high. How can it impact Indian stock market?

The US 10-year Treasury yields are near their 16-year high level boosted by the prospects of another rate hike. Federal Reserve Chairman Jerome Powell on Thursday said that more interest rate hikes may be required to bring inflation down to a 2 per cent target because of a tight labour market and resilient US economy.

As Mint reported, Federal Reserve Chair Jerome Powell said on Thursday, October 19, that inflation in the US remains too high and bringing it down to the Fed's 2 per cent target level will likely require a slower-growing economy and job market.

US bond yields have gone up significantly, nearing the highest levels in 16 years. The prime reason for this is the uncertainty about future interest rates in the US. A few weeks ago, everyone thought that there would be only one more rate hike. However, experts point out that Fed Chairman Powell on Thursday surprised everyone by suggesting that there might be more rate hikes in the future due to the strong economy and tight job market.

Experts observed that just when markets were assuming that rates were high enough, this view from the Chief renewed the nervousness and brought US 10-year yields near the 5 per cent mark. These levels were last seen in the year 2007.

On Friday, US 10-year bond yields declined over a per cent and hovered near 4.94 per cent.

Why are US bond yields rising?

Bond yields are influenced by the Federal Reserve's interest rates. Experts say bond yields have been rising because of the current trend of higher interest rates. This can also be seen as an indirect signal of rising inflation and the anticipation of a potential economic slowdown, which in turn makes the cost of borrowing money higher.

Apart from this, increased bond supply and and macro as well as geopolitical uncertainty have also contributed to the rise in bond yields.

"The recent surge in nominal long-end yields has been led by: (1) increased supply in recent quarters, (2) higher real yields (which rose as markets faded recession risks) contributing more than inflation expectations (which have trended down amid negative inflation surprises in recent months), and (3) Fed repricing and soft landing narrative leading to higher term premia," observed Madhavi Arora, Lead Economist at Emkay Global Financial Services.

Alok Agarwal, Portfolio Manager at Alchemy Capital Management pointed out that since the early 1980s, US interest rates had been declining.

"Following the Global Financial Crisis, the Federal Reserve chose to implement Quantitative Easing, an extraordinary stimulus program that included interest rate reductions and the purchase of government bonds," said Agarwal.

"Several attempts to restore normalcy have been attempted over the past ten years, but the markets have always responded with 'tantrums' particularly in 2013. A few months into the second effort, the world saw the outbreak of Covid, which unleashed even more easing, to the point that at one point over $15 trillion of global capital was invested in government bonds with negative yields," Agarwal said.

Agarwal underscored that the US inflation stayed under control during this entire period. But starting in 2021, the inflation reached multiyear and multi-decade highs, compelling the central banker to hike interest rates at a rate that has not been witnessed in at least four decades.

Also Read: Mysterious rise in US Treasury yields perturbs markets

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How can high US bond yields impact the Indian stock market?

When US bond yields rise, foreign portfolio investors (FPIs) often divest from emerging market equities and allocate their investments towards US bonds. This shift is driven by the perception that bonds are less risky than equities and offer more attractive return potential.

Kaushik Dani, Fund Manager - PMS, Abans Investment Managers also believes higher bond yields are negative for the stocks.

He pointed out that high bond yields make elevated equity markets less attractive and risk-averse investors are the first ones to change the asset allocation. The risk-off strategy leads foreign investors to pull out money from emerging markets like India. This is because dollar returns for FPIs are better in US Treasury versus equities during that period.

Dani said not only foreign investors but even domestic institutions with hybrid objectives tend to shift funds from equity to debt. Overall, outflows from equities will keep the stock market under selling pressure, especially when valuations are trading at a premium to other emerging markets, Dani added.

Also Read: Bond market going through a rough patch; should equity investors be worried? Experts weigh in

Pawan Bharaddia, the co-founder of Equitree pointed out that higher bond yields generally lead to a flight of capital from equity to bond markets which we have been experiencing over the last two years where FIIs have been net sellers to the tune of nearly ₹2,78,000 crore in the calendar year 2022 and ₹37,000 crore since the beginning of the calendar year 2023.

Bharaddia said since equity valuation is inversely related to bond yields, one is seeing the concept of value investing coming back in vogue over the last couple of years leading to renewed interest in small and mid-cap companies.

"We believe that as the higher interest rate is likely to continue so will the genre of value investing continue attracting more interest in the small and mid-cap space," said Bharaddia.

Also Read: Why investing in US bonds may not be a good idea

Manish Chowdhury, Head of Research at StoxBox believes with the current 2 per cent inflation target being the lone data point focus for the Fed, any rate cut hopes have been pushed forward to late 2024. This may exert pressure on equities.

"With risk aversion being the order of the day, we may see some pain in high-yielding assets including Indian equities. The saviour for our markets is the overall well-rounded shape of the economy further supported by improved corporate earnings and rising domestic participation in markets," Chowdhury said.

Also Read: 9 things to consider before investing in bonds in high interest rate scenario

Madhavi Arora of Emkay said still-rich equity valuations face increasing risk from high real rates and cost of capital, while earnings expectations for next year appear overly optimistic.

"Lags in the impact of high rates are longer this time, but we believe most of the negative effects are still to come. Our outlook on equities is to remain cautious ahead," said Arora.

Agarwal of Alchemy Capital Management underscored rising rates are intuitively not positive for equity markets. He said with US Treasury bonds giving 5 per cent dollar returns, the ask rate for equities goes up significantly if one were to adjust for risk premium and currency hedging.

Agarwal, however, believes the Indian market may fare better despite higher interest rates because of its robust economic growth prospects.

"India is in a special place. Finding another significant economy with a double-digit increase in corporate profits, double-digit nominal GDP growth, and double-digit ROEs (return on equities) is challenging. Higher rates imply that capital is not free or simple to obtain. However, it is never a barrier to something like what India provides, which is growth certainty. Rising rates are not a sign of strong equity, but given its advantages, India is predicted to fare better," said Agarwal.

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