Beyond the Bond Market’s Message
Outside of hardcore market participants, not many people are aware of an ongoing crash in one of the largest markets in the world—the US bond market. Since March 2020, the 10-year US treasury bond has crashed by 46%, while the 30-year bond has plunged by 53%. It is important to note that this is similar to the worst stock-market losses in history. In 2001, the US S&P 500 index had slumped 49% after the dot-com bubble burst; in the crash of 2008, the index collapsed 57%. The difference is that these equity market crashes happened in the space of a year, while the bond market crash happened over three years. Bond prices and bond yields are inversely correlated. When bond prices crash, yields go up. On Friday, as the bond price crash continued, the yield on the US 30-year bond hit 5%; this was last seen in January 2003 and reflects a seven-time increase from around 0.7% in March 2020.
All this has come as a shock to the markets. In early 2023, there were expectations that the US Federal Reserve (the Fed) would be done with increasing interest rates and look at cutting rates, since inflation has moderated. The world is now realising that the Fed is in no mood to cut rates as long as the US economic data is strong. Indeed, the buzzword is 'higher for longer'. There could even be a rate hike. Cleveland Fed head Loretta Mester was quoted as saying: “I suspect we may well need to raise the fed funds rate once more this year and then hold it there for some time as we accumulate more information on economic developments.”
How does this unprecedented move in US bond markets affect us? According to orthodox investment theory, sharply rising bond yields will lead to lower equity prices, as equities become less attractive, compared to the higher yield that bonds will now offer. To become more attractive, equity prices and those of other risk assets have to drop. No surprise then, that US equity markets have been under pressure and rising US bond yields are one of the reasons foreign investors are selling Indian equities in huge quantities. In August, they recorded net sales of Rs20,620 crore and in September Rs26,692 crore. In October, net sales have been Rs8,412 crore in one week. Along with rising bond yields, oil has been on the boil, leading to further pressure on equities.
Due to a combination of favourable circumstances and good fiscal management, the bond market has been steady. But, on Friday, the 10-year yield suddenly shot up by 1.73%, the biggest one-day move in the last year after the Reserve Bank of India (RBI) announced, in its monetary policy, that it would sell bonds to manage liquidity. That apart, the situation is somewhat different now. In the past, India and other developing markets caught a cold when the US sneezed. No longer. More domestic savings are headed into our markets through mutual funds and provident funds and that is countering the sales by foreigners. The Rs47,300 crore in sales pressed by foreign investors in August and September was almost entirely matched by Rs45,300 crore of buying by domestic institutional investors. What happens next? To get a sense of where we are headed, especially in an election year, we need to track three factors, apart from higher bond yields.
The first is global economic sluggishness. A couple of months ago, I had highlighted dark clouds over the global economy since China and Europe have been struggling to grow, and the US fiscal deficit seems out of control. India’s biggest weakness is its external sector. A slight global sluggishness is immediately reflected in poor Indian merchandise exports and a weaker rupee. This gloomy picture is likely to continue in the immediate future. The second is rising oil prices caused by supply cuts by Russia and the Organization of Petroleum Exporting Countries (OPEC). On 5th September, Saudi Arabia announced that it would extend its 1 million barrel per day production cuts while Russia has announced a cut of 300,000 barrels per day—both till the end of the year. Russia needs higher prices to pay for the Ukraine war, while Saudi Arabia needs higher oil prices to finance crown prince Mohammed bin Salman’s government projects, such as building a US$500 billion futuristic city. Oil prices rose 40% in July-September before correcting, but last Saturday, Israel and Palestine declared war, which could push oil prices higher again. A US$100/barrel oil price will put India in major trouble.
The third and the biggest factor that will determine the course of the economy and markets is India’s fiscal condition and its ability to fund the most important driver of the economy today—the Rs10 lakh crore in capital spending on infrastructure from the 2023-24 Budget that is going into water, urban transportation, railways, highways, and integrated logistics.
What can put a spanner in this main growth driver of the economy is the higher cost of borrowing due to higher bond yields, pressure on the rupee due to poor exports, higher oil prices and, finally, muted tax collections. Keep an eye on them.
(This article first appeared in Business Standard newspaper) 
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