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The BSE Sensex, India’s most popular stock market index, fell by 1,939 points or 3.8% today to close the day at 49,050 points.

Why did this happen? Stock prices in India are very closely related to how stock prices move in the United States (US), a day earlier. Yesterday, the Dow Jones Industrial Average, the premier stock market index in the US, fell by 560 points or 1.75% to 31,402 points.

This fall was primarily on account of the US government bond yields going up. The US government sells bonds which pay a certain rate of interest to finance its fiscal deficit or the difference between what it earns and what it spends.

Yesterday, the yield or the return on the 10-year US government bond rose above 1.5%, the highest it has been in more than one year. The yield has gradually been going up for a month, but yesterday it just spiked up. The yield on a bond is the return an investor can expect when he or she buys the bond on a given day and at a given price and holds on to it till maturity.

The 10-year US bond yield went up primarily because the investors expect inflation in the US to go up in the months to come. The belief is that as more and more people get vaccinated and go back to doing what they have always done, eating out, shopping, taking holidays, borrowing and generally buying stuff, the consumer demand will go up.

The supply will not be able to keep pace with increase in demand, leading to more money chasing the same set of goods and services, and hence, an increase in prices in general or higher inflation.

A higher inflation will mean interest rates across the economy will go up as well.

Investors do not wait for things to play out, they start factoring in their beliefs and the possibilities of various scenarios playing out, by acting on it immediately. With returns from fixed income investments which offer an interest likely to go up, investors sold out of stocks.

Investments offering fixed returns are less risky and when they offer higher returns than in the past, they become more attractive to invest in. Hence, investors move money out of stocks, which are riskier. This is something that happened yesterday in the US and today in India.

Of course, everyone doesn’t act based on a theory. Some investors simply sell out because others are selling out. And beyond a point stock prices fall because stock prices fall.

Over and above this, the US government bonds are deemed to be the safest financial securities in the world. If the returns from these bonds go up, the prices of all other financial assets adjust downwards.

With interest rates in the US suddenly looking more attractive, it is hardly surprising that foreign investors must have dumped Indian stocks today.

Further, with the rate of return on US bonds going up, a similar thing is happening with Indian bonds as well. The yield on the 10-year Indian government bond rose to 6.23% today, a jump of 20 basis points from February 17. One basis point is one hundredth of a percentage.

This implies interest rates in India are likely to go up, making stocks a less attractive proposition.

Vivek Kaul is the author of Bad Money.

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