How will the surge in US bond yields rub-off on other asset classes?

Brokerage firm Emkay Institutional Equities attributed the rise in US bond yields to three major factors.

First, there has been an increase in the supply of bonds in recent quarters due to the high deficit in the US. When the government borrows more money, investors demand a higher premium to lend that money which in turn lifts yields on the bonds.

Second, the yields on US 10-year bonds were already sitting at elevated levels even before the most recent surge as the market was pricing in higher interest rates for a longer tenure with inflation not coming down at the pace expected and fresh concerns over persistent price rise keeping investors worried. Hence, when the recent surge in yields happened, it lifted it to levels last seen in 2007.

Third, the Federal Reserve’s optimism to stage a soft landing has also evoked fears of the central bank sticking with its rate hike campaign until inflation cools down to the targeted level of two percent in the US. Along with that, other concerns including the spike in oil prices, and geopolitical concerns which are now heightened by the Israel-Hamas crisis are also contributing factors. The upshot: no rate cuts in sight; further rise can’t be ruled out.

Impact on India’s debt market

The impact of the surge in US treasury yields to a 16-year high has reverberated across all asset classes, including bond markets across the globe. The impact of the rising yield amid the global sell-off in the bond market are many. However, the Indian debt market may continue to be insulated from the global turmoil.

Currently, the US 10-year Treasury is available at a yield of 5.01 percent, while the Indian 10-year government bond is available at a 7.37 percent yield, and the spread between the two has narrowed to 2.3985 percentage points, which is the lowest since May 2006. The differential between the yields doesn’t reflect the full extent of the risk, since India’s credit rating is four notches lower than the US, at BBB-, while the US, in spite of seeing a downgrade, has an AA+ rating according to Standard & Poor’s. Thus, as is the case with other global markets traditionally, higher US yields should mean outflows from India, especially in terms of debt investments, with all other variables being the same, said Nishit Master, Portfolio Manager, Axis Securities PMS. But, it is actually the reverse.

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The net flow from FPIs in the debt market is less than $3 billion, with flows from FPIs remaining positive post-March 2023. The quantum of foreign flows is thus not significant enough to cause a dent in the yields. More importantly, India’s inclusion in the JPMorgan Emerging Market Bond Index, is likely to result in more than $20 billion in fund flows into the Indian debt market next year, said Deepak Agrawal, CIO - fixed income, Kotak AMC. This quantum could be different depending on how much money remains in the emerging market pool when the index starts to reset. But, there will be net inflows still. Thus, analysts are not too worried about the rise in yield in India.

How it will impact Indian equities

The rising US bond yields are a clear negative for equities, especially those in emerging markets such as India as it takes away the incentive to invest in these markets after adjustments due to currency fluctuations.

Following that trend, foreign institutional investors have also offloaded local equities to the tune of Rs 13,412 crore in the month so far. This comes after FIIs remained net sellers in the past two months, dumping local equities worth Rs 47,313 crore. Most market participants fear that a sustained elevation of the US bond yields may hamper the course of domestic equities, intensifying the selling from FIIs.

The heat of rising US bond yields has already seeped into domestic equities as the two benchmarks - the Nifty 50 and the Sensex have fallen for the sixth straight session on October 26, with the Nifty even slipping below the 19,000 mark.

"Rising rates are intuitively not positive for equity markets. With US government bonds giving 5 percent dollar returns, the ask rate for equities goes up significantly if one were to adjust for risk premium and currency hedging," said Alok Agarwal, Portfolio Manager at Alchemy Capital Management.

Risk premium is the extra gains investors expect when they choose to invest in riskier assets like emerging market stocks. This is because there is also a higher chance of losing money when investing in emerging market equities as compared to safer havens. In simpler terms, risk premium is the reward investors expect for being willing to take on more risk. Currency hedging is a way for investors to protect their investments even if the exchange rate goes against them.

Sunil Koul, Asia Pacific Portfolio Strategist at Goldman Sachs also said in an interaction to CNBC-TV18 that global equities look expensive if one looks from the standpoint of where the US 10-year bond yields are currently. "Adding to that, the macro headwinds of higher oil prices and a stronger dollar index will cumulatively impact foreign inflows," Koul added.

However, sustained buying from domestic institutional investors will likely insulate the domestic market from witnessing a meteoric fall. “Our market is likely to withstand the surge in US yields better than other emerging market counterparts thanks to our resilient macros, pick-up in consumption due to the festive season and sustained buying from domestic investors,” Narendra Solanki, Head of Fundamental Research at Anand Rathi Shares and Stock Brokers.

On that account, Solanki foresees a prolonged phase of consolidation in the domestic stock market, but believes that sectors having substantial FII holdings such as banks and information technology may see outflows.

Impact on currency, other asset classes

The impact of the rising yields on other asset classes such as commodities and currencies can no longer be seen in a silo. Historically, higher US yields are accompanied by a stronger dollar, since dollars usually tend to chase higher yields (if yield in US rises, money flows back to the US, strengthening the US dollar), said Bhavik Patel, Senior Commodities and Currency Analyst, Tradebulls Securities.

A strong dollar usually has a highly negative correlation with gold and crude prices. However, this has been broken by geopolitical uncertainties and the risk premium is being built in crude and gold, which are rising in tandem with bond yields, breaking from tradition.

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After the US 10-year treasury yield reached the 5.00 percent mark, US bond markets began to recover on October 25, with the dollar dipping to 105.4 levels. Nevertheless, given the strong US PMI (Purchasing Managers' Index) and positive corporate earnings, the dollar rebounded past 106 levels on October 25. Given the risk aversion in global markets, the dollar could continue to strengthen, posing a threat to all asset classes.

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