How India and US bond markets are moving and lessons for investors

Joydeep Sen

As a thumb rule, when the economy is expected to grow at a brisk pace, equity prices move up and bond yields move up as well, since demand for money would be more, thereby pushing up interest rates. Similarly, when the economy is sagging, bond yields come down as demand for money is that much lower and interest rates ease accordingly. However, the current developments in both US and Indian markets defy this convention. Let us look at the market movements.

In the US, there was a ‘preparation phase’ for a long time, on the exit from exceptionally low interest rates that was administered in the wake of the Global Financial Crisis (GFC). The ‘exit’ started with the tapering and eventual withdrawal of the bond buyback programme of USD 85 billion per month, which was meant to inject liquidity into the system. Finally, from December 2015, the US Fed FOMC started raising signal interest rates. The overnight rate, which was 0 percent to 0.25 percent at that point of time, was raised by 25 bps to 0.25 percent to 0.5 percent in December 2015. Till date, they have raised rates by 1 percent, bringing the overnight rate to 1 percent to 1.25 percent. It is expected that the US Fed will continue hiking rates, rather normalising it because they are exiting from exceptionally low rates, at an appropriate pace over the next couple of years. As per the Staff Economic Projections (SEP) of the US Fed, popularly known as the dot plot, the terminal rate at the end of the rate normalization cycle is expected to be somewhere around 3 percent.

In this situation, what do you expect? You would expect the US Treasury yield to move up, right? Now listen to this: US Treasury yield is lower now, than in December 2015 prior to the initiation of the rate hike cycle. US Treasury 10-year yield is at 2.16 percent now (26 June closing), lower than 2.2 percent-2.25 percent in December 2015. Puzzling? Former Fed chairman Alan Greenspan used a term ‘conundrum’ for this kind of situation, which cannot be explained by conventional logic. US equity markets are booming, Dow Jones is at 21,409 now and S&P 500 is at 2,439 (26 June closing). The market does not expect the economy to slow down, which may have required the US Fed to slow down rate normalization. That is to say, given the buoyancy in the equity market, the US economy is not expected to sag. The US Fed is expected to continue rate hikes at a pace appropriate for them, but the US bond market is ignoring that aspect.